Extreme Networks Annual Report 2005

Plain-text annual report

Table of ContentsUNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549 Form 10-K (Mark One)xxANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended July 3, 2005 OR ¨¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934 For the transition period from to . Commission file number 000-25711 Extreme Networks, Inc.(Exact name of Registrant as specified in its charter) Delaware 77-0430270(State or other jurisdiction ofincorporation or organization) (I.R.S. EmployerIdentification No.)3585 Monroe StreetSanta Clara, California 95051(Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 579-2800 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act:Common stock, $.001 par value Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, tothe best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or anyamendment to this Form 10-K. x Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes ¨ No x The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $764,679,249 as of December 23, 2004, the lastbusiness day of the Registrant’s most recently completed second fiscal quarter, based upon the closing price on The Nasdaq National Market reported forsuch date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose. 123,195,650 shares of the Registrant’s Common stock, $.001 par value, were outstanding August 15, 2005. DOCUMENTS INCORPORATED BY REFERENCE The information called for by Part III is incorporated by reference to specified portions of the Registrant’s Definitive Proxy Statement to be issued inconjunction with the Registrant’s 2005 Annual Meeting of Stockholders, which is expected to be filed not later than 120 days after the Registrant’s fiscalyear ended July 3, 2005. Table of ContentsEXTREME NETWORKS, INC. FORM 10-K INDEX PagePART IItem 1. Business 3Item 2. Properties 20Item 3. Legal Proceedings 20Item 4. Submission of Matters to a Vote of Security Holders 21PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 23Item 6. Selected Financial Data 23Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 24Item 7A. Quantitative and Qualitative Disclosures About Market Risk 54Item 8. Financial Statements and Supplementary Data 56Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 87Item 9A. Controls and Procedures 87PART IIIItem 10. Directors and Executive Officers of the Registrant 89Item 11. Executive Compensation 89Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 89Item 13. Certain Relationships and Related Transactions 89Item 14. Principal Accounting Fees and Services 89PART IVItem 15. Exhibits and Financial Statement Schedules 89SIGNATURES 93 2Table of Contents PART I FORWARD LOOKING STATEMENTS This annual report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, particularly statements relating to our expectations for the first quarter of fiscal 2006, our expectations regarding results ofoperations, our ability to expand our market penetration, our ability to expand our distribution channels, customer acceptance of our products, our ability tomeet the expectations of our customers, product demand and revenue, cash flows, product gross margins, our expectations to continue to develop newproducts and enhance existing products, our expectations regarding the amount of our research and development expenses, our expectations relating to ourselling, general and administrative expenses, our efforts to achieve additional operating efficiencies and to review and improve our business systems and coststructure, our expectations to continue investing in technology, resources and infrastructure, our expectations concerning the availability of products fromsuppliers and contract manufacturers, anticipated product costs and sales prices, our expectations that we have sufficient capital to meet our requirements forat least the next twelve months, our expectations regarding the rationalization of our workforce and facilities, and our expectations regarding materials andinventory management. These forward-looking statements involve risks and uncertainties, and the cautionary statements set forth below and those containedin the section entitled “Risk Factors” identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. We caution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certainrisk factors identified in this Form 10-K and other filings we have made with the Securities and Exchange Commission. More information about potentialfactors that could affect our business and financial results is set forth under “Risk Factors” and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.” Item 1. Business Overview Extreme Networks, Inc., together with its subsidiaries, (collectively referred to as Extreme or the Company and as we, us and our) is a leading providerof network infrastructure equipment for corporate, government, education and health care enterprises and metropolitan telecommunications service providers.We were established in 1996 to address the issues caused by slow and expensive legacy networks. We endeavored to change the industry by replacingcomplex software-based routers with simple, fast, highly intelligent, hardware-based network switches. The broad acceptance of this innovative, simplifiedapproach to networking has enabled us to become an industry leader. Our ultimate goal is to realize our technology vision of Ethernet Everywhere — aunifying network strategy that uses proven Ethernet technology to simplify each element of the network. We believe our Ethernet Everywhere vision is thefoundation for a future of easily deployable, highly scalable, comprehensively managed, ubiquitous bandwidth for networks, applications and users. Our family of switching products provides significant performance improvements compared to legacy network infrastructures, while enabling greaterflexibility and scalability, ease-of-use and a lower cost of ownership. We have achieved these advantages by utilizing Application Specific Integrated Circuits, or ASICs, as well as merchant silicon in our products and bycreating a common hardware, software and network management architecture for our products. In our products, the routing of network traffic, a functionreferred to as Layer 3 switching, is done primarily with our unique chipsets that provide faster processing of data than the CPU/software implementationsused in many conventional networking products. We believe that our unique hardware and software designs can also provide a better price/performance ratio,resulting in a higher return on investment for our customers. Since chipsets are built for specific purposes, it allows for a lower cost structure with increasedperformance compared to other alternatives. 3Table of ContentsIndustry Background Businesses, governments, educational institutions, health care enterprises and other organizations have become highly dependent on their internalnetworks and the Internet as their central communications infrastructure for providing connectivity for both internal and external communications. Newcomputing applications, such as enterprise resource planning or customer relationship management systems, large enterprise data warehouses andsophisticated online transaction and other e-business applications, as well as the increased use of traditional applications such as e-mail and streaming media,require the support of significant information technology resources. The emergence of the desktop Internet browser as a standard user interface as well as theInternet Protocol, or IP, as a common, enabling network technology has enabled bandwidth-intensive applications that integrate voice, video and data overTCP/IP to be deployed extensively throughout organizations. The steady rise in application sophistication and the associated bandwidth load demands afast, flexible and scalable network infrastructure. Networking environments can be segmented into local area networks, or LANs, wide area networks, or WANs, and metropolitan area networks, orMetros. LANs. LANs are traditional networks designed for connecting users to many types of application servers, which may be held locally or remotelythrough either private WANs or through such systems as the Internet. The LAN consists of servers, clients, a network operating system and a communicationslink to connect the LAN to other networks and to the Internet. The LAN market in which Extreme participates consists primarily of large and medium-sizedenterprise customers. WANs. WANs are communication networks that span across large geographic areas, such as counties, states or countries. The addition of WAN support to ASIC-based or merchant silicon-based network switches permits encapsulated Ethernet services to reach customerswhere integration with existing Synchronous Optical Network/Synchronous Digital Hierarchy, or SONET/SDH, infrastructure is required. The WAN market includes service providers such as local exchange carriers, or ILECs, and competitive local exchange carriers, or CLECs, multipletenant/dwelling unit service providers, or MTUs, and Internet service providers, or ISPs, as primary customers, though an enterprise may also utilize a privateWAN by using dark fiber, or unused fiber-optic cable, to connect their private LANs together. Metros. Metros are networks that link mid-sized geographic areas such as a city or an entire metropolitan area. Due to wide and steady deployment of increasingly scalable Ethernet technology, LAN traffic has achieved geometric growth in the aggregate amountsof data traffic delivered over networks and bandwidth rates, now delivered at Gigabit and 10 Gigabit speeds. Available bandwidth in WANs has also grown,as infrastructures are built out to accommodate the annual growth in Internet traffic. The Metro network has emerged as the key link between the LAN and theWAN. In recent years, the Metro network has become a critical and dynamically evolving arena within the overall IP network infrastructure landscape. Inaddition to steadily rising traffic load, the underlying network technologies, architectures and protocols are experiencing incremental change. Thecompetitive landscape for Metro service providers is shifting, with an influx of new carriers who do not necessarily depend upon legacy network transmissiontechnologies such as SONET/SDH to deliver frame relay or ATM subscriber services. The Metro market includes both ILECs and CLECs as well as alternative metropolitan service providers like utility companies, railroads andmunicipalities that provide Metro network services to connect multiple facilities. For example, a local government might build a Metro network tointerconnect agencies, such as city hall, fire departments, road and vehicle maintenance facilities, hospitals and emergency centers, social services and public 4Table of Contentslibraries. The same technologies and network architectures associated with Metros are becoming popular within large and very large corporate enterprises,which can utilize private Metros, by lighting “dark” fiber optic cabling, to create a “super campus” network, connecting facilities spread over a city-size area. A network must be scalable in the following four dimensions: Speed. Speed refers to the number of bits per second that can be transmitted across the network. Today’s network applications increasingly requirespeeds of up to 100 Mbps to the desktop. Therefore, the backbone and server connections that aggregate traffic from desktops require speeds in excess of 100Mbps. “Wire-speed” refers to the ability of a network device to process an incoming data stream at the highest possible rate based on the full capability of thephysical media, or wire without loss of packets. Wire-speed routing refers to the ability to perform Layer 3 switching at the maximum possible rate. Bandwidth. Bandwidth refers to the volume of traffic that a network or a network device can handle before traffic is “blocked,” or unable to get throughwithout interruption. When traffic was more predictable, the amount of traffic across a network link or through a network device generally grew in line withthe number of devices connected to the network. With today’s data-intensive applications accessed in random patterns from both within and outside the corenetwork, traffic can spike unpredictably, consuming significant bandwidth to the detriment of the network’s overall performance. Network size. Network size refers to the number of users and servers or end points that are connected to a network. Today’s networks must be capable ofreliably connecting tens of thousands of users and servers while providing high performance connectivity which results in maximum availability for bothnetworked applications and services. Quality of Service. Quality of Service refers to the ability to control the forwarding of traffic based upon its level of importance. Mission-criticalenterprise applications, such as Voice-over-Internet Protocol, or VoIP, require specific performance minimums, while traffic such as general e-mail andInternet surfing may not be as critical. In addition to basic prioritization of traffic according to importance, enhanced Quality of Service also allocatesbandwidth to specific applications based on a manager-defined policy. Opportunity for Next Generation Switching Solutions Several technology trends have enabled a new generation of networking equipment that can meet the four scalability dimensions required by today’senterprises and service providers and the bandwidth-intensive, mission-critical applications on which they depend. While many different network transmission technologies such as FDDI, Token Ring and ATM have been deployed in the LAN environment over thepast 25 years, Ethernet has become the overwhelmingly dominant LAN technology. Ethernet was evolved from its original 10 Mbps form in continual andsignificant improvements, from 100 Mbps Fast Ethernet, to 1,000 Mbps, or “Gigabit” Ethernet to 10,000 Mbps or 10 Gigabit Ethernet, which becameavailable during 2002. Today, Ethernet is moving beyond the LAN; Gigabit Ethernet and 10 Gigabit Ethernet technologies represent a viable, high-capacitytransport technology option for Metro backbones based on IP, enabling broadband connections to be aggregated for transport across the core of the Metro. With the widespread adoption of Ethernet and IP, the need to support a multi-transport, multi-protocol environment is diminishing. As a result,simplified routing functionality can be embedded in fast, inexpensive chipsets to replace complex software/CPU designs used in conventional multi-protocolrouters. The resulting device, called a Layer 3 switch, functions as a less expensive and significantly faster hardware-based router. Layer 3 switches operate atmulti-gigabit speeds and can support large networks. While Layer 3 switching dramatically increases network performance, many products fail to realize thepotential of this technology as a result of inconsistent hardware, software and management architectures. 5Table of ContentsCustomers require a Quality of Service solution that supports both industry-standard bandwidth prioritization and manager-defined Quality of Servicethat maps business processes and policies to network performance. In addition, to simplify the network, customers need a family of interoperable devices thatutilize a consistent hardware, software and management architecture. A variety of new requirements are now being placed on the enterprise LAN network. These requirements include seamless mobility within theenterprise, network and data security and IP Telephony support. These requirements offer great opportunity for next generation switching solutions.Switching solutions have to address the performance requirements, ease of deployment and ease of management of wireless LAN’s, security and IPTelephony. The Extreme Networks Solution We provide Ethernet networking solutions that meet the requirements of today’s enterprises and service providers by providing high performance,scalability, policy-based Quality of Service, simplicity of use and lower cost of ownership. Our products share a common hardware, software and networkmanagement architecture, are based on industry-standard routing and network management protocols and offer advanced policy-based Quality of Servicefeatures. Our switches can be managed from any browser-equipped computer or the Telnet applet supported in almost all operating systems. The Telnet appletallows access to the Command Line Interface, or CLI, which a system administrator may prefer to use. The key benefits of our solutions are: Lower cost of ownership. Our products are generally less expensive than software-based routers, yet offer higher routing performance. We believe thatby sharing a common hardware, software and management architecture, our products can substantially reduce the cost and complexity of networkmanagement and administration. This uniform architecture creates a simpler network infrastructure that leverages the resources businesses have invested inEthernet/IP-based networks, thereby requiring fewer resources and less time to maintain the network. Simplicity. Networks typically consist of many different technologies and types of equipment. This complexity often makes it expensive and difficultto effectively manage and expand networks. We meet these challenges by focusing on product consistency and simplicity. Our products share a commonhardware, software and network management architecture and enable Layer 3 switching at wire-speed in each key area of the network. This allows customersto build an integrated network environment that utilizes a consistent feature set, performance and management capabilities. Ease-of-use and implementation. Our wired LAN, wireless LAN, and security products are designed to make networks easy to manage and administer,thereby reducing the overall cost of network ownership. Through the use of a standards-based design approach, our products can be readily integrated intoexisting networks. Customers can usually upgrade to our products without the need for additional training. Moreover, our ExtremeWare® and ExtremeWare®XOS™ operating systems simplify network management with a consistent, robust interface available in all product families. High performance. Our products provide broadband Ethernet and IP services with the non-blocking, wire-speed performance of an ASIC-based ormerchant silicon-based Layer 3 switching engine. With our switches, customers may achieve forwarding rates that are significantly faster than software-basedrouters. Scalability. Our solutions offer customers the speed and bandwidth needed today — and the capability to scale their networks to support demandingapplications in the future — without the burden of additional training or software and system complexity. Customers who purchase standard Extremeproducts may later upgrade to advanced Layer 3 and Layer 4 features, such as server load balancing or intermediate-to-intermediate system routing protocol,or ISIS, as this upgraded functionality is designed into our products. 6Table of ContentsQuality of Service. Our policy-based Quality of Service enables customers to prioritize mission-critical applications. We provide industry-leading toolsfor allocating network resources to specific applications. With our policy-based Quality of Service, customers can use a web-based interface to identify andcontrol the forwarding of traffic from specific applications, in accordance with policies that the customers define. The Quality of Service functionality of ourchipsets allows policy-based Quality of Service to be performed at wire-speed. In addition to providing prioritization, customers can allocate specifiedamounts of bandwidth to specific applications or users. The Extreme Networks Strategy Our goal is to be the provider of the most innovative and effective network solutions that create an improved applications and services infrastructurefor enterprises and service providers. We seek to provide our customers with a best-of-breed alternative to single-sourced, highly proprietary networkingequipment from larger competitors. Key elements of our strategy include: Provide simple, easy-to-use, high-performance, cost-effective switching solutions. We offer customers easy to use, powerful, cost-effective switchingsolutions that meet the specific demands of enterprises, and service and content providers. Our products provide customers with scalability from 10 MbpsEthernet to 10 Gigabit Ethernet combined with the wire-speed, non-blocked routing of ASIC-based or merchant silicon-based Layer 3 switching. We intendto capitalize on our expertise in Ethernet, IP and hardware-based switching technologies to continuously develop new products that will meet the futurerequirements of a broad range of customers. Expand market penetration. We continue to market our products to new customers in multiple market segments. The majority of our business is withenterprise customers, including those in government, education and the health care sectors, in addition to middle to large commercial enterprises. Extremehas consistently focused on these markets since early in our history. Additionally, we aim to leverage our technology development, service and support andbusiness infrastructure resources to address the metropolitan Ethernet market. These service provider customers include ISPs, content providers and Metroservice providers. While currently most of our service provider and Metro-related business is generated outside of the United States, we believe there is along-term growth opportunity in the metropolitan Ethernet market on a worldwide basis. Once customers deploy our products they obtain the increasedbenefits of our solution by simplifying their networks, extending policy-based Quality of Service and reducing costs of ownership, while increasingperformance. Extend switching technology leadership. Our technological leadership is based on proprietary technology embedded in our chipsets, theExtremeWare® and ExtremeWare® XOS™ operating systems and network management and software. We intend to invest our engineering resources inchipsets, software and other development areas to create leading-edge technologies that will increase the performance and functionality of our products. Wealso intend to maintain our active role in industry standards committees such as the Institute for Electrical and Electronics Engineers, or IEEE, and theInternet Engineering Task Force, or IETF. Leverage and expand multiple distribution channels. We distribute our products through select distributors and a large number of resellers. To quicklyreach a broad, worldwide audience, we have more than 300 resellers in approximately 50 countries, including regional networking system resellers, networkintegrators and wholesale distributors. We maintain a field sales force to support our resellers and to sell directly to a small number of select strategicaccounts. We are continually developing and refining our two-tier distribution channel strategy. Provide high-quality customer service and support. We seek to enhance customer satisfaction and build customer loyalty through high-quality serviceand support. This includes a wide range of standard support programs that provide the level of service our customers require, from standard business hours toglobal 24-hour-a-day, 365-day-a-year real-time response support. We intend to continue to enhance the ease of use of our 7Table of Contentsproducts, and to invest in additional support services by increasing staff and adding new support programs for our distributors and resellers. We arecommitted to providing customer-driven product functionality through feedback from key prospects, consultants, channel partners and end-user customers. Products We deliver hardware-based network switches with a robust operating system and services infrastructure for enterprises and service providers based onaward-winning technology that combines simplicity, high performance, intelligence and a low cost of ownership. Our Layer 3 Summit, BlackDiamond andAlpine products share the same common hardware and operating system, enabling businesses to build a network infrastructure that is simple, easy to manageand scalable to meet the demands of future growth. Our award-winning 2nd Generation Inferno ASIC and 3rd Generation Triumph chipsets are incorporated in all i-series products, including theBlackDiamond and Alpine. Inferno provides the core technology for high-end Summit switches. During the past fiscal year, Extreme Networks introduced key new products that allow for the continued deployment of secure, converged networks aswell as the expansion of the ExtremeWare® XOS™ operating system from the core to the edge of the network. The following products were introduced: theBlackDiamond 8800 modular switch, a next generation Layer 3 chassis switch for converged networks; the Summit 400-24p fixed switch featuring Powerover Ethernet (PoE) Gigabit ports to support IP phones as well as UniStack stacking capabilities to manage multiple devices as one; the Summit 300-24switch, a Unified Access switch designed for the edge of the network with lower port densities and support for Wireless LANs; and the Summit X450 fixedswitch, the first fixed device featuring the ExtremeWare® XOS™ operating system and IPv6 capabilities. Extreme also announced its first network securityproduct, the CLEAR-Flow network security rules engine and the accompanying Sentriant Virtualized Security Resource (VSR), an automated threatdetection, containment and mitigation device. Our principal products are as follows: Products Configuration/DescriptionSummit Stackable Product Family Summit1i 6 100/1000 BaseT Ethernet ports and 2 1000BaseX Gigabit Ethernet portsSummit5i 12 100/1000 BaseT Ethernet ports and 4 1000BaseX Gigabit Ethernet portsSummit7i 28 100/1000 BaseT Ethernet ports and 4 1000BaseX Gigabit Ethernet portsSummit48si 48 10/100 Mbps Ethernet ports and 2 Gigabit Ethernet portsSummit 300 48 or 24 10/100 Mbps Ethernet ports, supporting Power over Ethernet, or PoE, andwireless functionality and 4 Gigabit Ethernet portsSummit WM 100/1000 Wireless switch controller supporting 2 Gigabit Ethernet ports or 4 fast 10/100 portsand up to 200 wireless Access Points 8Table of ContentsProducts Configuration/DescriptionSummit 200 48 or 24 10/100 Mbps Ethernet ports and 2 Gigabit Ethernet portsSummit 400 48 or 24 10/100/1000 BaseT Ethernet ports, 4 Gigabit Ethernet 1000BaseX ports andan optional 2-port 10 Gigabit Ethernet Module. The 24 port model supports Powerover Ethernet.Summit X450 24 10/100/1000 BaseT Ethernet ports or 24 Gigabit Ethernet fiber ports, including 4dual personality (fiber or copper) Gigabit Ethernet ports and an optional 2-port 10Gigabit Ethernet ModuleBlackDiamond Modular Chassis BlackDiamond 6804 Up to 384 10/100 Mbps Ethernet ports, 96 Gigabit Ethernet ports, or four 10 GigabitEthernet ports in one chassis 6 slots to accommodate a variety of up to 4 connectivity modules and 2 managementmodulesBlackDiamond 6808 Up to 672 10/100 Mbps Ethernet ports, 168 Gigabit Ethernet ports, or eight 10Gigabit Ethernet ports in one chassis 10 slots to accommodate a variety of up to 8 connectivity modules and 2 managementmodulesBlackDiamond 6816 Up to 1,440 10/100 Mbps Ethernet ports, 360 Gigabit Ethernet ports, or sixteen 10Gigabit Ethernet ports in one chassis 20 slots to accommodate a variety of up to 16 connectivity modules and 4management modulesBlackDiamond 8810 432 10/100/1000 Gigabit Ethernet ports, or 36 10 Gigabit Ethernet ports in onechassis 10 slots to accommodate a variety of up to 8 connectivity modules and 2 managementmodulesBlackDiamond 10808 480 Gigabit Ethernet ports, or 48 10 Gigabit Ethernet ports in one chassis 10 slots to accommodate a variety of up to 8 connectivity modules and 2 managementmodulesAlpine Modular Chassis Alpine 3802 Up to 64 10/100 Mbps Ethernet ports or 20 Gigabit Ethernet ports in one chassis 3 slots to accommodate a variety of up to 2 connectivity modules and 1 WAN module 9Table of ContentsProducts Configuration/DescriptionAlpine 3804 Up to 128 10/100 Mbps Ethernet ports or 64 Gigabit Ethernet ports in one chassis 5 slots to accommodate a variety of up to 4 connectivity modules and 1 managementmoduleAlpine 3808 Up to 256 10/100 Mbps Ethernet ports or 128 Gigabit Ethernet ports in one chassis 9 slots to accommodate a variety of up to 8 connectivity modules and 1 managementmoduleOperating Systems ExtremeWare® An embedded switch operating system featuring standard protocols, web-basedconfiguration and policy-based Quality of Service.ExtremeWare® XOS™ A scalable, Unix-based modular switch operating system supporting open APIs fordevice to device collaboration and support for XML type interfaces. ExtremeWare®XOS™ delivers automated process restart for highly available networks Summit Stackable Products The Summit family of switches is designed to meet the demanding requirements of Enterprise and metropolitan-Ethernet-based applications. AllInferno-chipset-based Summit switches share a common switch architecture that provides scalability in four areas: speed, bandwidth, network size and policy-based Quality of Service. The Summit product family supports Gigabit and 10/100 Mbps aggregation for enterprise desktops and servers, large Internet datacenters and broadband points of presence in Metros. Extreme has expanded the Summit 400 family of fixed switches which now includes the Summit 400-48t, the Summit 400-24p and Summit 400-24t.These switches serve the edge of high capacity networks while delivering high availability and connectivity enabling communications convergence. Bydelivering superior Gigabit Ethernet density and matching throughput performance, the Summit 400-48t (Summit 400) enables deployment of newintelligent services faster and more efficiently than ever before. The Summit 400 series is a part of Extreme Networks’ Unified Access (UA) architecture for theenterprise edge. The Summit 400-24p includes Power over Ethernet ports, Gigabit connectivity, and integrated stacking with optional 10 Gigabit uplinkswhich enables users to avoid costly upgrades as they deploy gigabit to the edge. The Summit 400-24p is the industry’s highest-performance, Layer 3, fixed-configuration switching platform with 101 Mbps throughput and 24 10/100/1000 ports. The Summit 300 switch, available in 48 or 24 port models, provides a unique set of capabilities as Extreme’s first Unified Access Architecture productsupporting both wired and wireless Ethernet connectivity. The Unified Access Architecture capabilities simplify the deployment of wireless by providingsimple to install access points (Altitude 300) that are managed from a single point, reducing the cost of ownership and providing uniform approaches tosecurity, authentication, Quality of Service and resiliency irrespective of the media connectivity type in use. 10Table of ContentsThe Summit 300 and Altitude access points enable unified access for wired and wireless applications at the network edge with the seamless integrationof 802.11 a/b/g type high performance wireless LAN connectivity, Power over Ethernet, and integrated Layer 3 routing intelligence. Unified AccessArchitecture is the industry’s most versatile solution for the integrated network edge where the network must progressively support an array of devicesincluding IP phones, laptop and desktop PCs and emerging devices such as IP cameras. Using Unified Access-enabled switches (the Summit 300-48) and theAltitude 300 access points, enterprises can simplify the installation and secure the operation of wired and wireless applications within a single “unified”infrastructure. The Summit 48si and the Summit 200 series switches allow us to remain an industry leader in Layer 3 switching for the desktop. The Summit 200-24and Summit 200-48 switches offer low entry costs for sophisticated Layer 2 and Layer 3 services, respectively, at the network edge. Additionally theSummit48si switch delivers an aggregation switching solution with physical and logical access, security and user mobility features at the edge. Other members of the Summit product line address server-switching constraints by providing switched Fast Ethernet or Gigabit Ethernet ports and highspeed Gigabit uplinks to servers, delivering required bandwidth between servers, and to clients on attached segments. In server farms and data centers, theSummit1i, Summit5i and Summit7i switches maximize server availability and performance by combining server load-balancing with wire-speed switching. The Summit WM 100/1000 – Wireless LAN Products Summit WM-series wireless LAN, or WLAN, controller delivers a high-performance wireless enterprise solution that is both secure and easy to manage.This allows Enterprise network managers to simplify the task of mobilizing their users without sacrificing features or performance. The Summit WM-seriesswitch is ready to support the most advanced wireless applications and mobile voice and multimedia networking challenges. Examples include cross-subnetroaming and sophisticated multicast. With capacities of up to 200 access points per switch, the Summit WM-series can scale to support the largest WLANinstallations while also providing centralized management for remote branch office installations. Sentriant – Virtualized Security Resource (VSR) The Sentriant VSR device, working with Extreme’s switch-based CLEAR-Flow security rules engine, delivers a dynamic network security system thatworks to proactively detect, contain and mitigate network threats including common denial of service attacks and harmful worm storms. The Sentriantappliance can be positioned at the core of the network where it eliminates threats in a matter of seconds with its ability to detect storm patterns and containmalicious traffic. Sentriant uses behavior-based threat detection methods to detect threats – including new threats for which no signatures exist at the time ofattack. It also includes a sophisticated early warning system that employs unused IP space to identify threats. The Sentriant VSR and CLEAR-Flow promotehigher network availability while reducing the need for numerous security devices across the edge of the network. BlackDiamond 10808 (10K) Series The BlackDiamond 10808, the first in the family of next-generation BlackDiamond 10K switches, represents the future of core Ethernet networking forboth enterprises and metropolitan service providers. Based on Extreme Networks’ revolutionary 4th Generation Network Silicon System (4GNSS), theBlackDiamond 10K is the first product to deliver programmable T-Flex technology, which allows programmability of the chipset to allow changes inprotocol support as new standards and protocols emerge. BlackDiamond 8800 Series The BlackDiamond 8800 series switch is designed for full-scale IP telephony deployments and high performance 10 Gigabit Ethernet. TheBlackDiamond 8800 modular switching solution enables users to address the critical requirements for voice production deployments: voice qualityconnectivity, increased uptime, better 11Table of Contentssecurity and simple management. The BlackDiamond 8800 promotes higher network availability for data and converged communications with its redundantdesign which is enhanced by a modular, highly-available, operating system, ExtremeWare® XOS™. The BlackDiamond 8800 provides Power over Ethernetconnectivity and the industry’s only LAN resiliency protocol for voice – Extreme Networks’ Ethernet Automatic Protection Switching (EAPS) protocol. BlackDiamond 6800 Series The BlackDiamond 6800 series switch delivers carrier-class scalability, redundancy and high reliability for core switching in high-density Ethernet/IPenterprise and service provider networks. These modular switches include the fault-tolerant features associated with mission-critical enterprise-class Layer 3core switching, including redundant system management and switch fabric modules, hot-swappable modules and chassis components, load-sharing powersupplies and management modules, up to eight 10 Mbps, 100 Mbps or Gigabit aggregated links, dual software images and system configurations, spanningtree and multipath routing, and redundant router protocols for enhanced system and network reliability. The BlackDiamond switch can accommodate up to16 I/O blades, including 10/100 Mbps, Gigabit and 10 Gigabit WAN interfaces. The network core is the most critical point in the network, serving as the convergence point for the majority of network traffic, including desktop,aggregation and server traffic. Network core switching involves switching traffic from desktops, segments and servers within the network. Owing to the high-traffic nature of the network core, the critical elements in core switching include wire-speed Layer 3 switching and routing, scalability, non-blockinghardware architecture, fault-tolerant mission-critical features, redundancy, and link aggregation capabilities. The ability to support a variety of high-densityport speeds and to accommodate an increasing number of high-capacity backbone connections is also important. The BlackDiamond 6800 series switch is certified to be compliant with Network Equipment Building Systems, or NEBS Level 3, and offers anextensive range of modules, including legacy connections such as Packet-over-SONET, or PoS, OC-3 and OC-12, and Asynchronous Transfer Mode, or ATM,metropolitan connectivity through Multi-Protocol Label Switching, or MPLS, billing capabilities through Accounting and Routing Module, opticalconnectivity with Wave Division Multiplexing, or WDM, and industry-leading 10 Gigabit Ethernet connectivity. Alpine 3800 Series The Alpine 3800 series switch provides a simple, resilient broadband infrastructure for Metros, ISPs and mid-range enterprise networks. The Alpine3800 series provides total Ethernet coverage with support for both standard category 5 and fiber optic media as well as first mile technologies that extend thereach of Ethernet-over-VDSL and legacy WAN technologies. The Alpine 3800 series switches can be configured to scale from 8 to 56 Ethernet-over-VDSL ports. Even higher density can be achieved with acombination of Ethernet-over-VDSL and traditional copper or fiber Ethernet ports. The FM-8Vi module provides Ethernet-over-VDSL at 10 Mbps full-duplexon each port, up to 2,500 feet. This product line has been significantly enhanced to support Extreme’s Unified Access Architecture with a new 24 port module that delivers Powerover Ethernet and management for integrated and secure WLAN connectivity. ExtremeWare® ExtremeWare® is the embedded operating system software that is featured on all of our switches. It delivers the robust switching and routing protocolsupport, management, control and security needed on current enterprise and service provider networks. Its standards-based, multi-layer switching and policy-based Quality of Service give network managers the tools needed to optimize network capacity with consistent fault-tolerant behavior. 12Table of ContentsExtremeWare® XOS™ Extreme Networks recognized in early 2000 that new operating system architecture would be needed as converged IP networks begin to drive more andmore mission-critical traffic onto a single network infrastructure. Culminating more than 3 years of research and development efforts, ExtremeWare® XOS™now delivers revolutionary breakthroughs and industry leading capabilities that further the state-of-the-art in networking technology: Scalability, Resiliency,Security and Extensibility. ExtremeWare® XOS™ provides a revolutionary software foundation that for the first time delivers adaptability, scalability andincreased responsiveness for enterprise networks through its uniquely open, extensible architecture. Sales, Marketing and Distribution We conduct our sales and marketing activities on a worldwide basis through a two-tier distribution channel utilizing distributors, value-added resellersand our field sales organization. A majority of our sales are currently made to partners in our distributor and reseller channels. The first tier consists of alimited number of independent distributors that sell primarily to resellers. The second tier of the distribution channel is comprised of a large number ofindependent resellers that sell directly to end-user customers. In addition, Extreme utilizes its field sales organization to sell direct to end-user customers,including large global accounts. Strategic Alliances. In October 2003 we entered into a mutual, non-exclusive, comprehensive strategic alliance with Avaya Inc. Avaya designs, buildsand manages communications networks for more than one million businesses worldwide, including 90 percent of the Fortune 500. Focused on businesseslarge to small, Avaya is a world leader in secure and reliable IP telephony systems and communications software applications and services. Avaya andExtreme are jointly developing and marketing converged communications solutions as part of this multi-year, multimillion-dollar strategic alliance. Avaya is also reselling Extreme Networks’ data networking products and will provide customers with comprehensive planning, design, implementationand management services support through Avaya Global Services. Distributors. We have established several key relationships with leading distributors in the electronics and computer networking industries. We intendto maintain these relationships with distributors who may offer products or distribution channels that complement our own channels. Each of our distributorsprimarily resells our products to resellers. The distributors enhance our ability to sell and provide support, especially global accounts, who may benefit fromthe broad service and product fulfillment capabilities offered by these distributors. One distributor, Tech Data, accounted for 11% of our net revenues in fiscal2005 and 2003. No distributor or customer accounted for more than 10% of our net revenues in fiscal 2004. Distributors are generally given privileges toreturn a portion of inventory to us for the purpose of stock rotation and participate in various cooperative marketing programs to promote the sale of ourproducts and services. We defer recognition of revenue on all sales to these distributors until the distributors sell the product, as evidenced by monthly“sales-out” reports that the distributors provide to us. (See “Revenue Recognition” in Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations.) Value-Added Resellers, or VARs. We have entered into agreements to sell our products through more than 300 resellers in approximately 50 countries.Our value-added resellers include regional networking system resellers, resellers who focus on specific vertical markets, network integrators and wholesaledistributors. We provide training and support to our resellers and our resellers generally provide the first level of support to end-users of our products. Ourrelationships with resellers are generally on a non-exclusive basis. Our resellers are not given privileges to return inventory and do not automaticallyparticipate in any cooperative marketing programs. We generally recognize product revenue from our reseller and end-user customers at the time of shipment,provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the salesproceeds is reasonably assured. When significant 13Table of Contentsobligations or contingencies remain after products are delivered, such as installation or customer acceptance, revenue and related costs are deferred until suchobligations or contingencies are satisfied. (See “Revenue Recognition” in Item 7. Management’s Discussion and Analysis of Financial Condition andResults of Operations.) Field sales. We have trained our field sales organization to support and develop leads for our value-added resellers and to establish and maintain alimited number of key accounts and strategic end user customers. To support these objectives, our field sales force: • assists end-user customers in finding solutions to complex network system and architecture problems; • differentiates the features and capabilities of our products from competitive offerings; • continually monitors and understands the evolving networking needs of enterprise and service provider customers; • promotes our products and ensures direct contact with current and potential customers; • partner with our key resellers to drive closure of business opportunities; and • monitors the changing requirements of our customers. As of July 3, 2005, our worldwide sales and marketing organization consisted of 309 individuals, including directors, managers, sales representatives,and technical and administrative support personnel. We have domestic sales offices located in 20 states and international sales offices located in 24countries. International sales International sales are an important portion of our business. In fiscal 2005, sales to customers outside of the United States accounted for 56% of ourconsolidated net revenues, compared to 61% in fiscal 2004 and 60% in fiscal 2003. These sales are conducted primarily through foreign-based distributorsand resellers managed by our worldwide sales organization, in addition to direct sales to end-user customers, including large global accounts. The primarymarkets for sales outside of the United States include the countries in Western Europe and Japan. Although not a significant component of total revenues todate, we have also achieved sales growth in the People’s Republic of China, countries throughout the Asia-Pacific region, South America, Canada andMexico. Marketing We have a number of marketing programs to support the sale and distribution of our products and to inform existing and potential customers and ourdistributors and resellers about the features and performance of our products. Our marketing efforts include participation in industry tradeshows, technicalconferences and technology seminars, preparation of competitive analyses, sales training, publication of technical and educational articles in industryjournals, a publicly available website, web-based training courses, advertising and public relations. In addition, we are developing e-commerce processes andsystems for our resellers, distributors and end-user customers. We also submit our products for independent product testing and evaluation. Backlog Our products are often sold on the basis of standard purchase orders that are cancelable prior to shipment without significant penalties. In addition,purchase orders are subject to changes in quantities of products and delivery schedules in order to reflect changes in customer requirements andmanufacturing capacity. Our business is characterized by seasonal variability in demand and short lead-time orders and delivery schedules. Actual shipmentsdepend on the then-current capacity of our contract manufacturer and the availability of materials and components from our vendors. We believe that only asmall portion of our order backlog is non-cancelable and that the dollar amount associated with the non-cancelable portion is not material. Accordingly, wedo not believe that backlog at any given time is a meaningful indicator of future revenue. 14Table of ContentsCustomer Support and Service We offer modular and comprehensive extended warranty service contracts under our ExtremeWorks service solutions to help protect our customers’network investments and support their business goals. The markets we address, including enterprises and service providers, all seek higher reliability andmaximum uptime. Our goal is to serve as a knowledgeable and experienced service partner who can tailor service solutions to meet the specific businessneeds of our customers. For the provision of on-site hardware support to customers we have strategic partnerships in place with International BusinessMachines, Inc. and Equant N.V. Expenses related to these agreements are recorded in cost of service revenue on our consolidated statements of operations.We also maintain relationships with Flextronics International, Ltd. and Solectron Corporation for the handling of product returns and repairs covered by ourwarranty and service contracts in various locations worldwide. We provide our customers with our standard, limited hardware warranty, which is typically 12months from the date of shipment to end-users and our 90-day software warranty. Warranty expenses related to these relationships are recorded in cost ofproduct revenue on our consolidated statements of operations. Our service offerings are as follows: • ExtremeWorks Professional Services • ExtremeWorks and PartnerWorks Support Programs • ExtremeWorks Education ExtremeWorks Professional Services. We specialize in providing solutions and consultative services to improve network productivity in all phases ofthe network lifecycle – planning, design, implementation, operation and optimization management. The professional services include customized andpackaged consulting services that assist customers in meeting their objectives for applications support, uptime and cost control. Our network architectsdevelop and execute customized hardware deployment plans to meet individualized network strategies. These activities include the management andcoordination of the design and network configuration, resource planning, staging, logistics, migration and deployment. We also provide customized trainingand operational best practices documentation to assist customers in the transition and sustaining of their networks. We offer our customers a variety of technical consulting services, including: • Analysis – detailed audit and analysis of customer networks • Policy-Based QoS – analysis and recommendation for deploying advanced traffic management and bandwidth prioritization features to matchactual traffic patterns • Multicasting – strategy for deploying PIM-DM, PIM-SM, or DVMRP to best suit streaming media requirements • Voice over IP – strategy and recommendations to deploy voice-over-IP utilizing our technology • Wireless LAN – site surveys, WLAN design and implementation of Unified Access solutions • Load Balancing – design and implementation of our integrated load balancing features to help maximize server response while reducingequipment costs • Security – analysis of customer security needs and recommendations on how to implement advanced security features to meet those needs • Resident engineering services – dedicated on-site technical engineering resources providing high level staff expertise ExtremeWorks and PartnerWorks Support Programs. Our support programs are designed to support a broad range of customer service requirements forour resale partners and direct customers. We meet the service requirements of our customers and channel partners through Technical Assistance Centers, orTACs, located in Santa Clara, California; Utrecht, Holland; Noida, India; and Tokyo, Japan. Our technical engineers assist in 15Table of Contentsdiagnosing and troubleshooting technical issues regarding customer networks. This is part of our effort to ensure maximum network uptime and performance.Regional systems engineers serve as on-site engineering resources to provide consultative support and advice for network operation on an as needed basis.Development engineers work with the TACs to resolve product functionality issues specific to each customer. We utilize the Internet to distribute and obtain information from our customer base as an integral part of our service solution. This allows us to keepcustomers informed of the latest updates and developments at Extreme Networks, and contains up-to-date information and technical documentation enablingcustomers to research issues and find answers to technical questions. Special features include a TAC database to obtain troubleshooting assistance andinformation for configuring software, diagnosing hardware, and researching network issues. On-site support services are available in most locationsworldwide for customers who require a more comprehensive level of service and support. ExtremeWorks Education. Leveraging our Authorized Training Partner strategy, Extreme Networks licenses partners to provide education throughcertified technical experts that teach classes dealing with all of our products. The classes cover a wide range of topics such as installation, configuration,operation, management and optimization – providing customers with the necessary knowledge and experience to successfully deploy and manage ourproducts in various networking environments. Classes are scheduled and available at numerous locations worldwide. Manufacturing We outsource the majority of our manufacturing and supply chain management operations as part of our strategy to maintain global manufacturingcapabilities and to reduce our costs. We conduct quality assurance, manufacturing engineering, document control and test development at our main campusin Santa Clara, California. This approach enables us to reduce fixed costs and to flexibly respond to changes in market demand. We have a strategic partnership with Flextronics International, Ltd. for the manufacture of our OEM products in San Jose, California and Guadalajara,Mexico. Flextronics’ manufacturing processes and procedures are ISO 9002 certified. Our commitment with Flextronics is formalized through a one-yearcontract. We design and develop the key components of our products, including ASICs and printed circuit boards. We determine the components that areincorporated in our products and select the appropriate suppliers of such components. Flextronics utilizes automated testing equipment to perform producttesting and burn-in with specified tests. Together we rely upon comprehensive inspection testing and statistical process controls to assure the quality andreliability of our products. We intend to regularly introduce new products and product enhancements that will require us to rapidly achieve volumeproduction by coordinating our efforts with those of our suppliers and contract manufacturer. Although we use standard parts and components for our products where it is appropriate, we currently purchase several key components used in themanufacture of our products from single or limited sources. Our principal single-source components include: • ASICs; • merchant silicon; • microprocessors; • programmable integrated circuits; • selected other integrated circuits; • custom power supplies; and • custom-tooled sheet metal. 16Table of ContentsOur principal limited-source components include: • flash memory; • dynamic and static random access memories, or DRAMS and SRAMS respectively; and • printed circuit boards. Purchase commitments with our single- or limited-source suppliers are generally on a purchase order basis. A number of vendors supply standardproduct integrated circuits and microprocessors for our products. Any interruption or delay in the supply of any of these components, or the inability toprocure these components from alternate sources at acceptable prices and within a reasonable time, may have a material adverse effect on our business,operating results and financial condition. Qualifying additional suppliers can be time-consuming and expensive and may increase the likelihood of errors. We use our forecast of expected demand to determine our material requirements. Lead times for materials and components vary significantly, anddepend on factors such as the specific supplier, contract terms and demand for a component at a given time. We order many of our materials and componentson an indirect basis through our contract manufacturer. Research and Development The success of our products to date is due in large part to our focus on research and development. We believe that continued success in the marketplacewill depend on our ability to develop new and enhanced products employing leading-edge technology. Accordingly, we are undertaking development effortswith an emphasis on increasing the reliability, performance and features of our family of products, and designing innovative products to reduce the overallnetwork operating costs of customers. Our product development activities focus on solving the needs of enterprises, service providers and Metro markets. Current activities include thecontinuing development of a next-generation chipset aimed at extending the capabilities of our products. Our ongoing research activities cover a broad rangeof areas, including, in particular, 10 Gigabit Ethernet, Metro and Internet routing software, ASIC design, network management software, broadband accessequipment and wireless networking equipment. We continued to enhance the functionality of our modular operating system (ExtremeWare® XOS™) which has been designed to provide highreliability and availability. This architecture allows us to leverage a common operating system architecture across different hardware and ASICimplementation. We intend to continue with this approach for future products and enhancements. As of July 3, 2005, our research and development organization consisted of 240 individuals. Research and development efforts are conducted inseveral locations in the U.S., including our headquarters in Santa Clara, California; Raleigh, North Carolina; and Westlake Village, California. In Fiscal 2005,we opened a research and development center in Chennai India focusing on the development and verification of our operating systems. Our research anddevelopment expenses in fiscal 2005, fiscal 2004 and fiscal 2003 were $61.3 million, $58.1 million, and $58.0 million, respectively. Competition The market for switches is part of the broader market for networking equipment, which is dominated by a few large companies, particularly CiscoSystems. In addition, there are a number of large telecommunications equipment providers, including Alcatel and Nortel Networks, which have entered themarket for network equipment, particularly through acquisitions of public and privately held companies. We expect to face increased competition,particularly price competition, from these and other telecommunications equipment providers. We also compete with other public and private companies thatoffer switching solutions, including Enterasys 17Table of ContentsNetworks, Inc., Foundry Networks, Inc., Huawei Technologies Corporation, 3Com Corporation, Hewlett-Packard Company and Dell Computer Corporation.These vendors offer products with functionality similar to our products or provide alternative network solutions. Current and potential competitors haveestablished or may establish cooperative relationships among themselves or with third parties to develop and offer competitive products. Furthermore, wecompete with numerous companies that offer routers and other technologies and devices that traditionally have managed the flow of traffic on the enterpriseor Metro networks. Some of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and otherresources, as well as greater name recognition and a larger installed customer base, than we do. As a result, these competitors are able to devote greaterresources to the development, promotion, sale and support of their products. In addition, competitors with a large installed customer base may have asignificant competitive advantage over us. We have encountered, and expect to continue to encounter, many potential customers who are confident in andcommitted to the product offerings of our principal competitors, including Cisco Systems. Accordingly, these potential customers may not consider orevaluate our products. When such potential customers have considered or evaluated our products, we have in the past lost, and expect in the future to lose,sales to some of these customers as large competitors have offered significant price discounts to secure these sales. We believe the principal competitive factors in the network switching market are: • expertise and familiarity with network protocols, network switching and network management; • product performance, features, functionality and reliability; • price/performance characteristics; • timeliness of new product introductions; • adoption of emerging industry standards; • customer service and support; • size and scope of distribution network; • brand name; • access to customers; and • size of installed customer base. We believe that we compete favorably with our competitors with respect to each of the foregoing factors. However, because many of our existing andpotential competitors have longer operating histories, greater name recognition, larger customer bases, broader product lines and substantially greaterfinancial, technical, sales, marketing and other resources, they may have larger distribution channels, stronger brand names, access to more customers and alarger installed customer base than we do. Such competitors may, among other things, be able to undertake more extensive marketing campaigns, adopt moreaggressive pricing policies and make more attractive offers to distribution partners than we can. To remain competitive, we believe that we must, among otherthings, invest significant resources in developing new products and enhancing our current products and maintain customer satisfaction worldwide. If we failto do so, our products will not compete favorably with those of our competitors and that may have a material adverse effect on our business. Intellectual Property We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.Based on our commitment to build a patent portfolio, we have in process a number of patent applications relating to our proprietary technology. We havefiled patent applications in selected countries abroad as deemed appropriate. There can be no assurance that these applications will be approved, that anyissued patents will protect our intellectual property, or that third parties 18Table of Contentswill not challenge these patents or applications. Furthermore, there can be no assurance that others will not independently develop similar or competingtechnology or design around any patents that we may obtain. With respect to trademarks, we have a number of pending and registered trademarks in theUnited States and abroad. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to, and distribution of,our software, documentation and other proprietary information. In addition, we provide our software products to end-user customers primarily under “shrink-wrap” license agreements included within the packaged software. These agreements are not negotiated with or signed by the licensee, and thus theseagreements may not be enforceable in some jurisdictions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy orotherwise obtain and use our products or technology. There can be no assurance that these precautions will prevent misappropriation or infringement of ourintellectual property. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. As detailed below under “Legal Proceedings,” we are currently engaged in litigation with Lucent Technologies, Inc. (“Lucent”) and EnterasysNetworks, Inc (“Enterasys”). Both Lucent and Enterasys are asserting claims that allege infringement of certain patent rights, against which we are defendingvigorously, but we cannot assure you that we will prevail in this litigation. In addition to the litigation with Lucent and Enterasys, in the normal course of ourbusiness from time to time, we are in discussions with companies that assert certain of our products require a license under a number of patents. Due to thenumber of companies with extensive patent portfolios in our industry who are or may be actively involved in licensing programs, we believe that even if wedo not infringe any patents, we may incur significant expenses in the future due to disputes or licensing negotiations, though the amounts and timing of suchexpenses cannot be determined with any reasonable certainty. As the functionality and features of our products expand, these disputes and discussions couldincrease or become harder to resolve. Employees As of July 3, 2005, we employed 834 people, including 309 in sales and marketing, 240 in engineering, 86 in operations, 88 in customer support andservice, and 111 in finance and administration. We have never had a work stoppage and no personnel are represented under collective bargaining agreements.We consider our employee relations to be good. We believe that our future success depends on our continued ability to attract, integrate, retain, train and motivate highly qualified personnel, andupon the continued service of our senior management and key personnel. None of our personnel is bound by an employment agreement. The market forqualified personnel is competitive, particularly in the San Francisco Bay Area, where our headquarters is located. At times, we have experienced difficultiesin attracting new personnel. Organization We were incorporated in California in May 1996 and reincorporated in Delaware in March 1999. Our corporate headquarters are located at 3585Monroe Street, Santa Clara, CA 95051 and our telephone number is (408) 579-2800. Our website can be found at www.extremenetworks.com. Investors canobtain copies of our SEC filings from this website free of charge, or on the SEC’s website at www.sec.gov. Our corporate governance guidelines, the charters of our audit committee, our compensation committee and our nominating and corporate governancecommittee and our code of ethics policy (including code of ethics provisions that apply to our principal executive officer, principal financial officers,controller and senior financial officers) are available on our website at www.extremenetworks.com under “Corporate Governance.” These items are alsoavailable to any stockholder who requests them by calling (408) 579-2800. 19Table of Contents Item 2. Properties Our principal administrative, sales, marketing and research and development facilities are located in Santa Clara, California. We also lease office spaceand executive suites in various other geographic locations domestically and internationally for sales and service personnel and engineering operations. Ouraggregate lease expense for fiscal 2005 was approximately $5.1 million, net of sublease income of approximately $0.4 million. We believe our currentfacilities will adequately meet our growth needs for the foreseeable future, and we are actively engaged in efforts to sublease excess space we acquired inprior years to meet the anticipated growth at that time. Item 3. Legal Proceedings On June 21, 2005, Enterasys filed suit against Extreme Networks and Foundry Networks, Inc. (“Foundry”) in the United States District Court for theDistrict of Delaware, Civil Action No.05-11298 DPW. The complaint alleges willful infringement of U. S. Patent Nos. 5,251,205; 5,390,173; 6,128,665;6,147,995; 6,539,022; and 6,560, 236, and seeks a judgment: (a) determining that we have willfully infringed each of the patents; (b) permanently enjoiningus from infringement, inducement of infringement and contributory infringement of each of the six patents; (c) awarding damages and a “reasonable royalty”to be determined at trial; (d) awarding trebled damages; (e) awarding attorneys fees, costs and interest; and (f) awarding equitable relief at the court’sdiscretion. We intend to evaluate the assertions, answer the complaint, and vigorously defend against Enterasys’ assertions which we believe to be withoutmerit. On May 27, 2003, Lucent filed suit against Extreme Networks and Foundry in the United States District Court for the District of Delaware, Civil ActionNo. 03-508. The complaint alleged willful infringement of U.S. Patent Nos. 4,769,810, 4,769,811, 4,914,650, 4,922,486 and 5,245,607. The judge split thecase into three parts to be tried separately: phase 1 to cover infringement, willfulness and damages; phase 2 to cover invalidity; and phase 3 to coverequitable defenses and our counterclaims. On May 9, 2005, a jury in Delaware awarded us a verdict in the phase 1 trial of non-infringement on 18 out of the19 claims asserted. The jury did award Lucent damages of approximately $275,000 on the remaining claim; which covers a feature that is not offered in ourcurrent product line. The parties each filed post-trial motions; and on August 16, 2005, the judge granted Lucent’s motion for a new trial, asserting thatExtreme improperly disclosed evidence of a past relationship with Lucent to the jury, and denied both parties’ other motions as moot. The new trial on phase1 and the remaining phases of the trial have not yet been scheduled. We intend to vigorously defend against Lucent’s claims and the judge’s current ruling,and to try the remainder of the case. Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint was brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8,1999 through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondaryoffering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings inexchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in theaftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. Theamended complaint also alleges that false analyst reports were issued. No specific damages are claimed. 20Table of ContentsSimilar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims underSection 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. We have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will notbe required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of theinsurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured. If thesettlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on ourconsolidated financial position, results of operations and cash flows in the future. Other than the proceedings stated above, we are not aware of any pending legal proceedings against us that, individually or in the aggregate, wouldhave a material adverse effect on our business, operating results or financial condition. We may in the future be party to litigation arising in the course of ourbusiness, including claims that we allegedly infringe third-party trademarks and other intellectual property rights. Such claims, even if not meritorious, couldresult in the expenditure of significant financial and managerial resources. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following table sets forth information regarding our executive officers as of August 1, 2005: Name Age PositionGordon L. Stitt 49 President, Chief Executive OfficerStephen Haddock 47 Vice President and Chief Technical OfficerHerb Schneider 46 Vice President of Research and DevelopmentWilliam R. Slakey 47 Senior Vice President and Chief Financial OfficerAlexander J. Gray 48 Chief Operating OfficerFrank C. Carlucci 42 Senior Vice President of Worldwide Sales Gordon L. Stitt. Mr. Stitt co-founded Extreme in May 1996 and has served as President, Chief Executive Officer and a director of Extreme since itsinception. From 1989 to 1995, Mr. Stitt worked at another company he co-founded, Network Peripherals, a designer and manufacturer of high-speednetworking technology. He served first as its Vice President of Marketing, then as Vice President and General Manager of the OEM Business Unit. Mr. Stittholds an M.B.A. from the Haas School of Business of the University of California, Berkeley and a B.S.E.E./C.S. from Santa Clara University. Stephen Haddock. Mr. Haddock co-founded Extreme in May 1996 and has served as Vice President and Chief Technical Officer of Extreme since itsinception. From 1989 to 1996, Mr. Haddock worked as Chief Engineer at Network Peripherals. Mr. Haddock is a member of IEEE, an editor of the GigabitEthernet Standard and Chairman of the IEEE 802.3ad link aggregation committee and vice chairman of the 10 Gigabit committee. Mr. Haddock holds anM.S.E.E. and a B.S.M.E. from Stanford University. 21Table of ContentsHerb Schneider. Mr. Schneider co-founded Extreme in May 1996 and has served as Vice President of Research and Development of Extreme since itsinception. From 1990 to 1996, Mr. Schneider worked as Engineering Manager at Network Peripherals and was responsible for the development of LANswitches. From 1981 to 1990, Mr. Schneider held various positions at National Semiconductor, a developer and manufacturer of semiconductor products,where he was involved in the development of early Ethernet chipsets and FDDI chipsets. Mr. Schneider holds a B.S.E.E. from the University of California –Davis. William R. Slakey. Mr. Slakey has served as Senior Vice President and Chief Financial Officer of Extreme Networks since October 2003. FromSeptember 2002 to September 2003, Mr. Slakey served as Vice President and Chief Financial Officer at Handspring, Inc., a maker of wireless communicationdevices and PDA’s. From October 2001 to August 2002, Mr. Slakey was Executive Vice President and Chief Financial Officer at WJ Communications, aleading RF semiconductor company. From September 1999 to December 2000, he was Chief Financial Officer at SnapTrack, a QUALCOMM company thatpioneered a GPS-based system for pinpointing wireless devices. Prior to SnapTrack, Mr. Slakey held various financial roles at Palm Computing, 3ComCorporation and Apple Computer. Mr. Slakey holds a B.A. degree in economics from the University of California and an M.B.A. from the Harvard GraduateSchool of Business Administration. Alexander J. Gray. Mr. Gray joined Extreme as Chief Operating Officer in September 2002. From January 2001 through August 2002, Mr. Gray wasChief Operating Officer at LGC Wireless, a telecommunications provider. From November 1999 until January 2001, Mr. Gray worked for Replay TV, a digitalmedia provider, as Executive Vice President of Business Operations. From December 1992 through October 1999, Mr. Gray held senior managementpositions with Lucent Technologies, Inc. and Octel Communications Corporation, both telecommunications providers. Prior to that time, Mr. Gray heldpositions as Director of Information Services for American President Lines, a container shipping company, from September 1991 to November 1992 andNEXT Computer, a computer and equipment manufacturer, from July 1988 to August 1991. He also spent four years as a research and development engineerfor Hewlett-Packard Company, a computer and equipment manufacturer. Mr. Gray holds a B.S. and an M.S. in Electrical Engineering from WashingtonUniversity in St. Louis, Missouri. Frank C. Carlucci. Mr. Carlucci joined Extreme as Senior Vice President of Worldwide Sales in July 2004. From April 2000 through June 2004, Mr.Carlucci held various executive positions with Avaya, Inc., a communications equipment and applications provider. Mr. Carlucci’s last position with Avayawas as Vice President of Global Outsourcing, prior to that role he had led Avaya’s largest sales region and operations for Avaya’s product group. From August1998 to April 2000, Mr. Carlucci was the Sales Vice President for a venture of Lucent Technologies. From July 1996 to August 1998, Mr. Carlucci heldvarious management positions at Federal Data Corporation, a systems integration company. From January 1993 to July 1996, Mr. Carlucci held variousmanagement positions at Nortel Networks, Inc., a telecommunication hardware manufacturer. From May 1991 through December 1992, Mr. Carlucci was afield sales manager for Ernest and Julio Gallo Winery. Mr. Carlucci served six years as an intelligence officer in the United States Navy following graduationfrom Georgetown University with a B.S. in International Politics. 22Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock commenced trading on The Nasdaq National Market on April 9, 1999 under the symbol “EXTR.” The following table sets forth thehigh and low sales prices as reported by Nasdaq. Such prices represent prices between dealers, do not include retail mark-ups, mark-downs or commissionsand may not represent actual transactions. Stock Prices High LowFiscal year ended July 3, 2005: First quarter $5.66 $4.38Second quarter $7.22 $4.30Third quarter $6.64 $5.65Fourth quarter $5.91 $4.07Fiscal year ended June 27, 2004: First quarter $8.98 $4.66Second quarter $10.46 $6.15Third quarter $10.60 $6.27Fourth quarter $8.20 $4.64 At August 15, 2005, there were approximately 348 stockholders of record of our common stock and approximately 40,000 beneficial stockholders. Wehave never declared or paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We currentlyintend to retain future earnings for the development of our business. Item 6. Selected Financial Data Year Ended July 3, 2005(1) June 27, 2004(2) June 29, 2003(3) June 30, 2002(4) July 1, 2001(5) (In thousands, except per share amounts) Consolidated Statements of Operations Data: Net revenues $383,347 $351,848 $363,276 $441,609 $491,232 Net income (loss) $12,942 $(1,748) $(197,180) $(183,962) $(68,883)Net income (loss) per share — basic $0.11 $(0.01) $(1.71) $(1.63) $(0.64)Net income (loss) per share — diluted $0.10 $(0.01) $(1.71) $(1.63) $(0.64)Shares used in per share calculation — basic 121,225 118,348 115,186 112,925 108,353 Shares used in per share calculation — diluted 124,219 118,348 115,186 112,925 108,353 As of July 3, 2005 June 27, 2004 June 29, 2003 June 30, 2002 July 1, 2001 (In thousands) Consolidated Balance Sheets Data: Cash and cash equivalents, short-term investments and marketable securities $440,404 $425,672 $402,157 $400,057 $191,502 Total assets $583,614 $579,273 $550,257 $736,344 $666,348 Convertible subordinated notes $200,000 $200,000 $200,000 $200,000 $— Other long-term liabilities $30,698 $41,308 $22,313 $20,761 $266 (1)Fiscal 2005 net income includes $0.1 million in amortization of deferred stock compensation, a $2.0 million expense related to the execution of atechnology agreement, and other income of $3.9 million from the relief of a foreign consumption tax obligation.(2)Fiscal 2004 net loss includes $1.1 million in amortization of deferred stock compensation, $6.5 million in restructuring charges for excess facilities,other income of $7.9 million in cash settlements from vendors, net of related expenses and other income of $2.5 million from the relief of a foreignconsumption tax obligation. 23Table of Contents(3)Fiscal 2003 net loss includes $0.7 million in amortization of deferred stock compensation, $15.9 million in restructuring charges, $12.7 million inproperty and equipment write-offs, $1.0 million in impairment of acquired intangible assets and a $132.2 million charge included in our tax provisionreflecting our provision of a full valuation allowance against deferred tax assets.(4)Fiscal 2002 net loss includes $10.2 million in amortization of deferred stock compensation, $37.2 million in amortization of goodwill and purchasedintangible assets, $73.6 million in restructuring charges and $89.8 million in impairment of intangible assets.(5)Fiscal 2001 net loss includes $4.1 million in amortization of deferred stock compensation, $33.4 million in amortization of goodwill and purchasedintangible assets, $30.2 million in write-offs of acquired in-process research and development and $5.9 million in restructuring charges. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Business Overview We develop and sell a family of modular and stackable network infrastructure equipment and offer related service contracts for extended warranty andmaintenance agreements. Substantially all of our revenue is derived from the sale of networking equipment and the related service contracts. We believe thatunderstanding the following key developments is helpful to an understanding of our operating results for fiscal 2005. Increased Product Breadth We believe that continued success in the marketplace will depend on our ability to develop new and enhanced products employing leading-edgetechnology. In fiscal 2005 we introduced several new products that allow for the continued deployment of secure, converged networks as well as theexpansion of the ExtremeWare® XOS™ operating system from the core to the edge of the network. The following products were introduced in fiscal 2005: theBlackDiamond 8800 modular switch, a next generation Layer 3 chassis switch for converged networks; the Summit 400-24p fixed switch featuring Powerover Ethernet (PoE) Gigabit ports to support IP phones as well as UniStack stacking capabilities to manage multiple devices as one; the Summit 300-24switch, a Unified Access switch designed for the edge of the network with lower port densities and support for Wireless LANs; and the Summit X450 fixedswitch, the first fixed device featuring the ExtremeWare® XOS™ operating system and IPv6 capabilities. Extreme also announced its first network securityproduct, the CLEAR-Flow network security rules engine and the accompanying Sentriant Virtualized Security Resource (VSR), an automated threatdetection, containment and mitigation device during the past fiscal year. Convergence of Voice, Video and Data We have a vision of providing customers with the systems to build a converged communications infrastructure that can easily accommodate voice,video and data on a seamless wired and wireless network. We believe that these two aspects of convergence: the convergence of voice, video and data, andthe convergence of wired and wireless are important underlying demand creators in the Enterprise market. In October 2003, we announced our comprehensive strategic alliance with Avaya, Inc. to jointly develop and market converged communicationssolutions. The alliance brings together Avaya’s global market leadership in IP voice and telephony with Extreme’s expertise in high performance IP datanetwork infrastructure. Under the Joint Development Agreement the companies plan to develop next generation, standards-based technologies in the areas ofnetwork management and provisioning, Quality of Service, security, and network resilience. Additionally, Avaya will sell, service and support Extreme’sentire portfolio of data networking products through their worldwide sales organization and the Avaya Global Services organization. Business Environment Throughout fiscal 2003 and early 2004, the primary factor that impacted our operations and financial performance was weak demand for networkingequipment resulting from the continuing weakness of the global and U.S. economies. Weak economic conditions persisted through most of fiscal 2004, butbeginning in the third 24Table of Contentsquarter of fiscal 2004, we began to see evidence of strengthening demand for our products. In fiscal 2005, we continued to generate revenue growth, althoughnot each and every quarter, and not in all geographic markets. While it is too early to determine if this improvement in demand will continue, we believe thatindustry demand has stabilized and is showing signs of returning to positive growth. Expanded Focus on Service Offering Extreme’s service offering is primarily the provision of service contracts for extended warranty and maintenance agreements related to our networkingequipment. To a lesser extent, the service revenue includes professional services related to the design and installation of data networks and training. In fiscal2005, we continued to focus our service sales efforts on increasing the number of service contracts sold with new equipment and on securing renewals onexpiring contracts. Additionally, we improved the efficiency of our service supply chain and reduced the cost of service revenue. Service revenue increasedby 21.7% in fiscal 2005 compared to fiscal 2004, and 26.0% in fiscal 2004 compared to fiscal 2003. Service revenue increased to 15.4% of total net revenuein fiscal 2005 from 13.8% in fiscal 2004. Cost of service revenue decreased by $1.3 million in fiscal 2005 to $34.2 million and service gross marginsimproved to 42.1% in fiscal 2005 compared to 26.8% in fiscal 2004. Results of Operations Our operations and financial performance have been affected by the economic factors described above, and given the strengthening demand for ourproducts during fiscal 2005, we were able to achieve the following results: • Net revenues of $383.3 million, an increase of 9.0% over fiscal 2004 net revenues of $351.8 million. • Service revenue of $59.1 million, an increase of 21.7% from fiscal 2004 service revenue of $48.6 million. • Total gross margin of 52.9% of net revenues, up from 50.9% in fiscal 2004. • A return to profitability for the first year since fiscal 2000 with net income of $12.9 million. • Cash and cash equivalents, short-term investments and marketable securities increased by $14.7 million to $440.4 million as of July 3, 2005. Net Revenues The following table presents net product and service revenues for the fiscal years 2005, 2004 and 2003 (dollars in thousands): Year Ended July 3,2005 % of NetRevenues June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues Net revenues: Product $324,256 84.6% $303,293 86.2% $324,727 89.4%Service 59,091 15.4% 48,555 13.8% 38,549 10.6% Total net revenues $383,347 100.0% $351,848 100.0% $363,276 100.0% Net revenues were $383.3 million in fiscal 2005, $351.8 million in fiscal 2004, and $363.3 million in fiscal 2003, representing an increase of 9.0% infiscal 2005 from fiscal 2004, and a decrease of 3.1% in fiscal 2004 from fiscal 2003. The increase in revenues in fiscal 2005 as compared to the decrease infiscal 2004 was generally due to an improvement in the demand for networking equipment after several years of weakness of the global and U.S. economies.Fiscal 2005 had 53 weeks, compared with 52 weeks in fiscal 2004, and we believe that this extra week may have had a positive impact on our sales. However,we are not able to quantify the effect of the slightly longer year on our revenue. 25Table of ContentsProduct revenue was $324.3 million in fiscal 2005, $303.3 million in fiscal 2004, and $324.7 million in fiscal 2003, representing an increase of 7.0%in fiscal 2005 from fiscal 2004, and a decrease of 6.6% in fiscal 2004 from fiscal 2003. The increase in product revenue in fiscal 2005 from fiscal 2004 wasprimarily due to an increase in unit volume, slightly offset by higher level of discounting. The decrease in product revenue in fiscal 2004 from fiscal 2003was primarily due to a change in mix in product demand, with both total units and average selling price remaining relatively stable. We expect that averageselling prices across the industry will continue to be subject to competitive pressure and may decline somewhat going forward. Service revenue was $59.1 million in fiscal 2005, or a 21.7% increase over fiscal 2004 service revenues of $48.6 million. Service revenue in fiscal 2004increased by 26.0% from fiscal 2003 service revenue of $38.5 million. The increase in service revenue in each of the fiscal years was the result of our focus onincreasing the number of service contracts initially sold with new products and increasing contract renewal rates, as well as changes in our pricing policiesregarding service. As a percentage of total net revenues, service revenue was 15.4% in fiscal 2005, 13.8% in fiscal 2004, and 10.6% in fiscal 2003. The following table presents the total net revenues geographically for the fiscal years 2005, 2004 and 2003 (dollars in thousands): Year Ended July 3,2005 % of NetRevenues June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues Net revenues: United States $167,027 43.6% $136,622 38.8% $144,066 39.7%Europe, Middle East and Africa 117,521 30.6% 93,700 26.6% 90,303 24.9%Japan 58,100 15.2% 77,600 22.1% 82,916 22.8%Other 40,699 10.6% 43,926 12.5% 45,991 12.6% $383,347 100.0% $351,848 100.0% $363,276 100.0% Revenues outside of the United States accounted for 56.4%, 61.2%, and 60.3% of net revenues in fiscal 2005, fiscal 2004, and fiscal 2003,respectively. Revenues in the U.S. in fiscal 2005 increased by $30.4 million, or 22.3% over the fiscal 2004 results. Revenues outside the U.S., as a percentageof total net revenues, in fiscal 2005 decreased by 4.8% compared to fiscal 2004 due to a decrease of 6.9% and 1.9% in net revenues in Japan and otherinternational regions, respectively, offset in part by an increase in net revenues in Europe, the Middle East and Africa of 4.0%. The decline in net revenue inJapan was a result of lower demand for networking products within the service provider customer segment. Revenue in Europe, the Middle East, and Africaincreased by $23.8 million, or 25.4%, in fiscal 2005 as compared to fiscal 2004. The 0.9% increase in net revenues outside the United States in fiscal 2004compared to fiscal 2003 was due to an increase of 1.7% in net revenue in Europe, the Middle East and Africa; a decrease of 0.7% in net revenues in Japan;and revenues in other international regions, primarily Asia Pacific, as a percentage of total net revenues remaining flat as a percent of the total. We expect thatexport sales will continue to represent a significant portion of net revenues, although export sales will fluctuate as a percentage of net revenues. Substantiallyall sales transactions are currently denominated in United States dollars. We rely upon multiple channels of distribution, including two-tiered distribution in which large distributors purchase our product and make itavailable to resellers. Revenue through our distributor channel was 38% of total product revenue in both fiscal 2005 and fiscal 2004. The level of sales to anyone customer, including a distributor, may vary from period to period; however, we expect that significant customer concentration will continue for theforeseeable future. One customer, Tech Data Corporation, who is a distributor of our products, accounted for 11% of our net revenues in fiscal 2005 and fiscal2003. No distributor or customer accounted for more than 10% of our net revenues in fiscal 2004. 26Table of ContentsCost of Revenues and Gross Margin The following table presents the gross margin on product and service revenues and the gross margin percentage of net revenues for the fiscal years2005, 2004 and 2003 (dollars in thousands): Year Ended July 3,2005 % of NetRevenues June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues Gross margin: Product $177,780 54.8% $166,187 54.8% $152,658 47.0%Service 24,872 42.1% 13,009 26.8% (2,303) -6.0% Total gross margin $202,652 52.9% $179,196 50.9% $150,355 41.4% Gross margin was $202.7 million in fiscal 2005, $179.2 million in fiscal 2004, and $150.4 million in fiscal 2003, representing an increase of 13.1% infiscal 2005 from fiscal 2004, and an increase of 19.2% in fiscal 2004 from fiscal 2003. Gross margin as a percentage of net revenues was 52.9%, 50.9%, and41.4% in fiscal 2005, fiscal 2004 and fiscal 2003, respectively. Cost of product revenue includes costs of raw materials, amounts paid to third-party contract manufacturers, costs related to warranty obligations,charges for excess and obsolete inventory, royalties under technology license agreements, and internal costs associated with manufacturing overhead,including management, manufacturing engineering, quality assurance, development of test plans, and document control. Product gross margin in fiscal 2005was $177.8 million, representing 54.8% of product revenues as compared to $166.2 million in fiscal 2004, or 54.8% of product revenue. Product gross marginpercentage in fiscal 2005 was flat with fiscal 2004 although we experienced a reduction in per-unit product costs, offset by increases in royalties paid to thirdparties for technology licenses, and $1.1 million higher warranty expense due to a change in the method we use to estimate warranty return rates. Cost of product revenue in all periods includes the cost of our manufacturing overhead. We outsource substantially all of our manufacturing andsupply chain management operations, and we conduct quality assurance, manufacturing engineering, document control and repairs at our facility in SantaClara, California. Accordingly, a significant portion of our cost of product revenue consists of payments to our primary contract manufacturer, FlextronicsInternational, Ltd. located in San Jose, California and Guadalajara, Mexico. Product gross margin in fiscal 2004 was $166.2 million, representing 54.8% of product revenues as compared to $152.7 million in fiscal 2003, or47.0% of product revenue. The increase in product gross margin percentage in fiscal 2004 was due to a reduction in per-unit product costs resulting from aconsolidation of volume at a single manufacturer. In addition, fiscal 2004 product gross margin was favorably impacted by a reduction in manufacturingoverhead, warranty expense, reductions in scrap, rework, and was negatively impacted by increases in excess inventory expenses. Our cost of service revenue consists primarily of labor, overhead, repair and freight costs and the cost of spares used in providing support undercustomer service contracts. Service gross margin in fiscal 2005 was $24.9 million, an increase of $11.9 million from fiscal 2004 gross margin of $13.0million. Service gross margin was 42.1% in fiscal 2005 as compared to 26.8% in fiscal 2004. Service gross margin in fiscal 2005 was favorably impacted bythe increase in service revenue and reduction in cost of service revenue, due primarily to a reduction in the costs associated with processing repairs andreplacements. Service gross margin was $13.0 million in fiscal 2004, representing 26.8% of service net revenue as compared to a negative gross margin of $2.3million in fiscal 2003. Service gross margin in fiscal 2003 was negatively impacted from the costs incurred by a number of programs that we implemented toimprove service delivery productivity and to enhance customer satisfaction. These programs included expenses incurred to increase service revenue andreduce service infrastructure, including outsourcing certain service functions. 27Table of ContentsOur product and service gross margins are variable and dependent on many factors, some of which are outside of our control. Some of the primaryfactors affecting gross margin include demand for our products, changes in our pricing policies and those of our competitors, and the mix of products sold.Our gross margin may be adversely affected by increases in material or labor costs, increases in warranty expense or the cost of providing services underextended service contracts, heightened price competition, obsolescence charges and higher inventory balances. In addition, our gross margin may fluctuatedue to the mix of distribution channels through which our products are sold, including the effects of our two-tier distribution model. Any significant declinein sales to our resellers, distributors or end-user customers, or the loss of any of our key resellers, distributors or end-user customers could have a materialadverse effect on our business, operating results and financial condition. In addition, an increase in distribution channels generally makes it more difficult toforecast the mix of products sold and the timing of orders from our customers. New product introductions may result in excess or obsolete inventories, whichmay also reduce our gross margin. Sales and Marketing Expenses Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing and sales functions, as well astrade shows and promotional expenses. Sales and marketing expenses were $96.8 million in fiscal 2005, $93.2 million in fiscal 2004, and $102.5 million infiscal 2003, representing an increase of 3.8% in fiscal 2005 from fiscal 2004, and a decrease of 9.0% in fiscal 2004 from fiscal 2003. The increase in fiscal2005 was primarily due to increases of $7.8 million in payroll and related personnel expenses, including sales commissions due to higher revenues, highertravel expenses of $0.9 million offset in part by lower marketing and promotional expenses of $2.7 million, lower meeting expenses of $0.3 million, lowerinformation technology costs of $1.1 million and lower depreciation of $1.1 million. The decrease in fiscal 2004 from fiscal 2003 was primarily due to adecrease in marketing and promotional expenses of $4.2 million as a result of cost-cutting measures, a decrease in depreciation expense of $1.7 million, adecrease in occupancy expenses of $1.0 million, a decrease in salaries and related personnel expenses of $1.2 million primarily due to lower salescommissions and a decrease in travel expenses of $1.0 million. As a percentage of net revenues, sales and marketing expenses were 25.3% in fiscal 2005,26.5% in fiscal 2004 and 28.2% in fiscal 2003. The level of our sales and marketing spending in the future, in dollars and as a percentage of net revenues willdepend on many factors, including most importantly the rate at which we expand our sales force and the rate at which our net revenues increase. Research and Development Expenses Research and development expenses consist principally of salaries and related personnel expenses, consultant fees and prototype expenses related tothe design, development, and testing of our products. Research and development expenses were $61.3 million in fiscal 2005, $58.1 million in fiscal 2004,and $58.0 million in fiscal 2003. Research and development expenses in fiscal 2005 include $6.0 million in amortization expense related to the fair value ofthe warrant issued to Avaya as part of the Joint Development Agreement, an increase of $2.0 million as compared to fiscal 2004. The fair value of the warrantallocated to the Joint Development Agreement with Avaya is $17.9 million and is being amortized over the term of the agreement (see Note 13 of Notes toConsolidated Financial Statements). Research and development costs also include an increase of $1.8 million related to our corporate quality initiative,offset by a reduction of $1.7 million in engineering project expenses associated with the recovery of costs under a third party development agreement that isnot expected to recur. Research and development expenses remained flat at $58 million in fiscal 2004 from fiscal 2003. Fiscal 2004 includes amortizationexpense of $4.0 million related to the fair value of the warrant issued to Avaya, offset in part by decreased payroll and personnel expenses of $1.6 million,decreased engineering project expenses of $1.2 million and decreased depreciation expense of $0.7 million. As a percentage of total net revenues, researchand development expenses were 16.0% in fiscal 2005, 16.5% in fiscal 2004, and 16.0% in fiscal 2003. We expense all research and development expenses asincurred. We believe that continued investment in research and development is critical to attaining our strategic objectives and as a result, we expect researchand development expenses to increase in absolute dollars. 28Table of ContentsGeneral and Administrative Expenses General and administrative expenses consist primarily of salaries and related expenses for executive, finance and administrative personnel, legal fees,professional fees and other general corporate expenses. General and administrative expenses were $31.8 million in fiscal 2005, $29.6 million in fiscal 2004,and $25.7 million in fiscal 2003, representing an increase of 7.3% in fiscal 2005 from fiscal 2004, and an increase of 15.0% in fiscal 2004 from fiscal 2003.The increase in fiscal 2005 from fiscal 2004 of $2.2 million was primarily due to a $1.8 million increase in legal expenses due to the litigation with Lucent,an increase in professional services expenses of $1.1 million, including audit fees, related to compliance with the Sarbanes-Oxley Act of 2002, an increase inpayroll and personnel related expenses of $1.1 million, partially offset by a $1.1 million decrease in insurance costs and a reduction in informationtechnology costs of $0.7 million. Legal expenses related to intellectual property litigation with Lucent are expected to continue but at lower levels than infiscal 2005. Expenses as a result of compliance with the Sarbanes-Oxley Act of 2002, and section 404 thereof, are expected to continue at similar or slightlylower levels than fiscal 2005. The increase in fiscal 2004 from fiscal 2003 was primarily due to increases in legal fees of $3.9 million relating to litigation andincreases in other professional fees of $1.3 million, offset by decreases in insurance expense of $0.8 million and decreases in payroll and personnel expensesof $0.5 million. As a percentage of net revenues, general and administrative expenses were 8.3% in fiscal 2005, 8.4% in fiscal 2004, and 7.1% in fiscal 2003.The rate of any future spending increases in our general and administrative expenses, if any, will depend on the level of legal expenses related to intellectualproperty litigation, including the Lucent and Enterasys actions, and expenses associated with complying with the Sarbanes-Oxley Act of 2002. Technology Agreement On March 31, 2005, we entered into a Patent and Cross License Agreement (“Technology Agreement”) with IBM. The agreement provides for a releaseof prior claims and a cross license of patents extending into the future from the effective date of the agreement. We charged the estimated value of the releaseof prior claims of $2.0 million to operating expenses in the quarter ended March 27, 2005 under the caption “Technology agreement”. The remaining costspayable under the Technology Agreement will be charged to cost of product revenue over the license term. We expect these costs to have a small impact onthe total product cost of revenue. Impairment of Acquired Intangible Assets During fiscal 2003, we performed our annual evaluation of goodwill for impairment in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 142 (“SFAS 142”), Goodwill and Other Intangible Assets. This evaluation indicated decreased expected future demand for the productsassociated with the goodwill and, therefore, we recorded an impairment charge of $1.0 million, representing the carrying value of goodwill at that time. Therewas no goodwill remaining as of July 3, 2005 or June 27, 2004. Amortization of Deferred Stock Compensation Amortization of deferred stock compensation was $0.1 million in fiscal 2005, $1.1 million in fiscal 2004, and $0.7 million in fiscal 2003, representinga decrease of $1.0 million in fiscal 2005 from fiscal 2004 and an increase of $0.4 million in fiscal 2004 from fiscal 2003. Amortization of deferred stockcompensation is attributable to unvested stock options subject to forfeiture issued to employees that we assumed in conjunction with acquisitions duringfiscal 2001. Deferred stock compensation is amortized as charges to operations, using the graded method, over the vesting periods of the individual stockoptions, generally four years. Upon termination of an employee, the amount of expense recognized under the graded vesting method that is in excess of theamount actually earned is reversed. For fiscal 2005, fiscal 2004, and fiscal 2003, we reversed zero, $0.4 million, and $5.3 million, respectively, of excesscompensation expense related to terminated employees. 29Table of ContentsRestructuring Charge During fiscal 2004, we recorded restructuring charges of $6.5 million related to excess facilities. The excess facilities charge represents an increase tothe charge initially recognized during the third quarter of fiscal 2002. The commercial real estate market continued to deteriorate in fiscal 2004 and we werenot able to find suitable tenants to sublease these facilities necessitating an additional charge due to lower projected sublease receipts. During fiscal 2003, we recorded restructuring charges of $15.9 million. The restructuring charges included excess facilities charges of $9.6 million,severance charges of $4.4 million and asset impairments of $1.9 million. The excess facility charge originally recognized in the third quarter of fiscal 2002was increased due to lower projected sublease income caused by the deterioration of the commercial real estate market. Severance charges of $4.4 millionwere recognized upon two separate reductions in total staff of approximately 170 people, or 18% of the total workforce, across all departments. The assetimpairment charge relates to the write-off of leasehold improvements and office furniture related to excess facilities. Property and Equipment Write-Off During fiscal 2003, we completed a property and equipment physical inventory in conjunction with the implementation of our new ERP system. Theproperty and equipment physical inventory resulted in the identification of $12.7 million of property and equipment whose fair value was determined to bezero because the assets were either no longer in service or were not identifiable. Therefore, these assets were written off during the second quarter of fiscal2003. Interest Income Interest income was $10.7 million in fiscal 2005, $8.6 million in fiscal 2004, and $11.1 million in fiscal 2003, representing an increase of $2.1 millionin fiscal 2005 from fiscal 2004, and a decrease of $2.5 million in fiscal 2004 from fiscal 2003. The increase in interest income in fiscal 2005 from fiscal 2004was due primarily to an increase in average interest rates and to a lessor extent, an increase in available investment balances due to positive cash flow fromoperations. The decrease in fiscal 2004 from fiscal 2003 was attributed to lower interest rates offset in part by an increase in available investment balancesdue to increased cash flow from operations. Interest Expense Interest expense was $7.0 million, $7.0 million, and $7.1 million in fiscal 2005, fiscal 2004, and fiscal 2003, respectively. Interest expense in each ofthe fiscal years presented is attributable to the $200.0 million of convertible subordinated notes. The notes mature in December 2006 and interest is payablesemi-annually at 3.5% per annum. Other Income (Expense), net Other income (expense), net was income of $2.1 million in fiscal 2005, income of $9.1 million in fiscal 2004, and expense of $0.2 million in fiscal2003. Other income in fiscal 2005 includes income of $3.9 million from the relief of a foreign consumption tax obligation, expense of $1.3 million foramortization of the costs associated with the $200.0 million convertible subordinated notes, and $0.6 million of foreign exchange losses due primarily to thedecline in the U.S. dollar relative to the Yen and the Euro. The tax holiday that generated the foreign consumption tax relief expired in fiscal 2005, and nofurther benefits are expected. Other income of $9.1 million in fiscal 2004 was primarily comprised of cash settlements from vendors, net of related expenses, of $7.9 million, relief ofa foreign consumption tax obligation of $2.5 million, and gains on the sale of investments $0.6 million, offset by other expenses of $1.4 million foramortization of costs associated with the convertible subordinated notes, and foreign exchange losses of $0.5 million. The cash settlements from vendorsrelated to disputes regarding quality issues pertaining to components supplied for use in our products. 30Table of ContentsOther expense in fiscal 2003 was primarily comprised of amortization of costs associated with the convertible subordinated notes of $1.2 million and awrite-down of investments in privately-held companies of $0.2 million, partially offset by realized gains on marketable securities of $1.6 million. Provision (Benefit) for Income Taxes The provisions for income taxes of $3.5 million and $3.2 million for fiscal 2005 and fiscal 2004, respectively, were recorded for taxes due on incomegenerated in certain states and foreign tax jurisdictions. The effective tax rate in fiscal 2005 was 21.5% which differs from the statutory tax rate due tobenefits for U.S. taxes from net operating loss carryforwards and tax credits, offset by the tax impact of income from foreign operations. As of July 3, 2005, wehad net operating loss carryforwards for federal and state tax purposes of $248.1 million and $18.8 million, respectively. We also had federal and state taxcredit carryforwards of $9.5 million and $12.1 million, respectively. Unused net operating loss and tax credit carryforwards will expire at various datesbeginning in the years 2006 and 2008, respectively. The provision for income taxes of $134.8 million for fiscal 2003 was attributable to $2.6 million for taxes due on income generated in foreign taxjurisdictions and a $132.2 million non-cash charge to income tax expense recorded in the fourth quarter of fiscal 2003, representing a full valuationallowance for our U.S. net deferred tax assets. We recorded this charge in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), whichplaces greater weight on previous cumulative losses than the outlook for future profitability when determining whether deferred tax assets can be realized.Based upon the three-year history of losses at the time the charge was incurred and relying on other guidance specified in SFAS 109, we determined that itwas appropriate to establish a full valuation allowance against our deferred tax assets. This valuation allowance will be evaluated periodically and can bereversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets. Critical Accounting Policies and Estimates Our significant accounting policies are more fully described in Note 2 of Notes to Consolidated Financial Statements included in Item 8 of this AnnualReport on Form 10-K. The preparation of consolidated financial statements in accordance with generally accepted accounting principles requiresmanagement to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assetsand liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By theirnature, these estimates, assumptions and judgments are subject to an inherent degree of uncertainty. We base our estimates, assumptions and judgments onhistorical experience, market trends and other factors that are believed to be reasonable under the circumstances. Estimates, assumptions and judgments arereviewed on an ongoing basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to benecessary. Actual results may differ from these estimates under different assumptions or conditions. Our significant accounting policies have been discussedwith the audit committee of the board of directors. We believe the critical accounting policies stated below, among others, affect our more significantjudgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated fromservice fees relating to the service contracts and training on our products. We generally recognize product revenue from our value-added resellers and end-user customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed ordeterminable and collection of the sales proceeds is reasonably assured. In instances where the criteria for revenue recognition are not met, revenue is deferreduntil all criteria have been met. Our total deferred product revenue was $1.6 million and $3.0 million as of July 3, 2005 and June 27, 2004, respectively.Revenue 31Table of Contentsfrom service obligations under service contracts is deferred and recognized on a straight-line basis over the contractual service period. Our total deferredrevenue for services, primarily from service contracts, was $48.9 million and $50.7 million as of July 3, 2005 and June 27, 2004, respectively. Servicecontracts typically range from one to five years. When sales arrangements contain multiple deliverables, such as hardware, service contracts and other services, we determine whether the deliverablesrepresent separate units of accounting and then allocate revenue to each unit of accounting based on their relative fair values. We recognize revenue for eachunit of accounting when the revenue recognition criteria for each unit of accounting are met. The amount of product revenue recognized is impacted by ourjudgments as to whether an arrangement includes multiple units of accounting and if so, whether fair value exists for those units of accounting. The ability toestablish fair value for any unit of accounting could affect the timing of the revenue recognition. We make certain sales to partners in two distribution channels, or tiers. The first tier consists of a limited number of independent distributors that sellprimarily to resellers and, on occasion, to end-user customers. We defer recognition of revenue on all sales to these distributors until the distributors sell theproduct, as evidenced by monthly “sales-out” reports that the distributors provide to us. We grant these distributors the right to return a portion of unsoldinventory to us for the purpose of stock rotation. We also grant these distributors certain price protection rights. The distributor-related deferred revenue andreceivables are adjusted at the time of the stock rotation return or price reduction. We also provide distributors with credits for changes in selling prices, andallow them to participate in cooperative marketing programs. We maintain estimated accruals and allowances for these exposures based upon our historicalexperience. If actual credits to distributors for changes in selling prices and cooperative marketing programs were to deviate significantly from our estimates,which are based on contractual arrangements and historical experience, our future revenue could be adversely affected. The second tier of the distribution channel consists of a large number of third-party value-added resellers that sell directly to end-users and aregenerally not granted return privileges, except for defective products during the warranty period. We reduce product revenue for certain price protectionrights that may occur under contractual arrangements we have with our resellers. We provide an allowance for sales returns based on our historical returns, analysis of credit memo data and our return policies. The allowance for salesreturns was $2.3 million and $2.2 million as of July 3, 2005 and June 27, 2004, respectively, for estimated future returns that were recorded as a reduction ofour accounts receivable. The provision for returns is charged to net revenues in the accompanying consolidated statements of operations, and was $1.0million in fiscal 2005, $1.8 million in fiscal 2004, and zero in fiscal 2003. If the historical data we use to calculate the estimated sales returns and allowancesdoes not properly reflect future levels of product returns, these estimates will be revised, thus resulting in an impact on future net revenues. We estimate andadjust this allowance at each balance sheet date. Inventory Valuation Our inventory balance was $25.9 million as of July 3, 2005, compared with $25.9 million as of June 27, 2004. We value our inventory at lower of cost(determined on a first-in, first-out basis) or market. The networking industry is characterized by rapid technological change, frequent new productintroductions, changes in customer requirements and evolving industry standards. We perform a detailed assessment of inventory at each balance sheet date,which includes a review of, among other factors, demand requirements, product lifecycle and product development plans and quality issues. Based on thisanalysis, we record adjustments, when appropriate, to reflect inventory at net realizable value. Inventory write-downs charged to cost of product revenue were$1.1 million in fiscal 2005, $1.3 million in fiscal 2004, and $0.4 million in fiscal 2003. Although we make every effort to ensure the accuracy of our forecastsof product demand, any significant unanticipated changes in demand or technological developments would significantly impact the value of our inventoryand our reported operating results. In the future, if we find that our estimates are too optimistic and we determine that our 32Table of Contentsinventory needs to be written down, we will be required to recognize such costs in our cost of product revenue at the time of such determination. Conversely,if we find our estimates are too pessimistic and we subsequently sell product that has previously been written down, our operating margin in that period willbe favorably impacted. Accrued Warranty Networking products may contain undetected hardware or software errors when new products or new versions or updates of existing products arereleased to the marketplace. We have experienced such errors in connection with products and product updates. Our standard hardware warranty period istypically 12 months from the date of shipment to end-users and 90 days for software. Upon shipment of products to our customers, including both end-usersand channel partners, we estimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability throughcharges to cost of product revenue for this amount. Our accrued warranty balance was $7.5 million as of July 3, 2005, compared with $8.3 million as of June 27, 2004. The determination of our warrantyrequirements is based on our actual historical experience with the product or product family, estimates of repair and replacement costs and any productwarranty problems that are identified after shipment. We estimate and adjust this accrual at each balance sheet date in accordance with changes in thesefactors. The cost of new warranties issued that was charged to cost of product revenue was $12.3 million in fiscal 2005, $11.8 million in fiscal 2004, and$15.5 million in fiscal 2003. While we believe that our warranty accrual is adequate and that the judgments applied in calculating this accrual areappropriate, the assumptions used are based on estimates and these estimated amounts could differ materially from our actual warranty expenses in the future.In fiscal 2005, we recognized $1.1 million in additional warranty expense due to a change in the method we use to accumulate the warranty return rates. Ifactual expenses exceed those we have estimated, our future cost of product revenue would be adversely affected. Allowance for Doubtful Accounts Our accounts receivable balance, net of allowance for doubtful accounts, was $30.8 million and $33.0 million as of July 3, 2005 and June 27, 2004,respectively. The allowance for doubtful accounts as of July 3, 2005 was $1.2 million, compared with $1.4 million as of June 27, 2004. The distributoraccounts receivable balance, net of allowance for doubtful accounts, recorded in prepaid expenses and other current assets, was $23.2 million and $20.4million as of July 3, 2005 and June 27, 2004, respectively. The allowance for doubtful distributor accounts, also recorded in prepaid expenses and othercurrent assets, as of July 3, 2005 was $0.6 million, compared with $0.7 million as of June 27, 2004. We continually monitor and evaluate the collectibility ofour trade receivables based on a combination of factors. We record specific allowances for bad debts in general and administrative expense when we becomeaware of a specific customer’s inability to meet its financial obligation to us, such as in the case of bankruptcy filings or deterioration of financial position.Estimates are used in determining our allowances for all other customers based on factors such as current trends in the length of time the receivables are pastdue and historical collection experience. We mitigate some collection risk by requiring most of our customers in the Asia-Pacific region, excluding Japan, topay cash in advance or secure letters of credit when placing an order with us. Our provision for doubtful accounts was an expense of $0.4 million in fiscal2005, a benefit of $0.2 million in fiscal 2004, and a benefit of $0.8 million in fiscal 2003. If a major customer’s creditworthiness deteriorates, or if actualdefaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverability of amounts due to us could be overstated,and additional allowances could be required. We write-off receivables to the allowance after all collection efforts are exhausted. In the fourth quarter of fiscal2005, one large distributor in Europe became delinquent in its payments to us due to cash flow problems and difficulty in obtaining financing. Although thiscustomer has committed to honor its obligations to us, we increased our allowance for doubtful accounts to cover a higher percentage of this customer’soutstanding balance. However, a complete default in payment by this customer would have an adverse affect on our results of operations and financialposition. 33Table of ContentsDeferred Tax Asset Valuation Allowance We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assetsand liabilities. Significant management judgment is required in determining our valuation allowance recorded against our net deferred tax assets. We makean assessment of the likelihood that our net deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not believed tobe likely, a valuation allowance is established. We provided a full valuation allowance against all of our U.S. federal and state net deferred tax assets in fiscal2003 in the amount of $163.1 million in accordance with the provisions of SFAS No. 109, Accounting for Income Taxes. In fiscal 2005, the valuationallowance increased by $3.1 million to $173.0 million, and in fiscal 2004, the valuation allowance increased by $6.8 million to $169.9 million. The valuation allowance was calculated in accordance with the provisions of SFAS 109, which requires an assessment of both negative and positiveevidence when measuring the need for a valuation allowance. In accordance with SFAS 109, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain. Our net losses in the three-year period at thetime the charge was incurred represented sufficient negative evidence to require a full valuation allowance against our net deferred tax assets under SFAS109. This valuation allowance will be evaluated periodically and can be reversed partially or totally if business results have sufficiently improved to supportrealization of our deferred tax assets. Legal Contingencies We are currently involved in various claims and legal proceedings, including negotiations regarding potential licenses from third parties who havenotified us that they believe our products may infringe certain patents. Periodically, we review the status of each significant matter, whether litigation orlicensing negotiation, and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and theamount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals, if any, are based only on themost current and dependable information available at any given time. As additional information becomes available, we may reassess the potential liabilityfrom pending claims and litigation and the probability of claims being successfully asserted against us. As a result, we may revise our estimates related tothese pending claims and litigation. Such revisions in the estimates of the potential liabilities could have a material impact on our consolidated results ofoperations, financial position and cash flows in the future. For further detail, see Note 4 of Notes to Consolidated Financial Statements for a description oflegal proceedings. Liquidity and Capital Resources Cash and cash equivalents, short-term investments and marketable securities were $440.4 million and $425.7 million at July 3, 2005 and June 27,2004, respectively, representing an increase of $14.7 million. This increase was primarily due to cash provided by operating activities of $16.5 million andproceeds from issuance of common stock of $5.9 million, partially offset by capital expenditures of $7.1 million, and an increase in the unrealized loss oninvestments of $0.5 million. We generated $16.5 million in cash from operations in fiscal 2005. Net income was $12.9 million and included significant non-cash charges includingdepreciation of $16.2 million and amortization expense related to the warrant issued to Avaya of $7.6 million. Accounts receivable, net decreased to $30.8million at July 3, 2005 from $33.0 million at June 27, 2004. Days sales outstanding in receivables decreased to 29 days at July 3, 2005 from 33 days at June27, 2004. The decrease in accounts receivable and days sales outstanding were primarily due to timing of collections. Inventory levels remained flat at $25.9million at July 3, 2005 and June 27, 2004. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels toensure competitive lead times and avoid stock-outs with the risk of inventory excess or obsolescence because of 34Table of Contentsdeclining demand, rapidly changing technology and customer requirements. Deferred revenue decreased to $50.5 million at July 3, 2005 from $53.7 millionat June 27, 2004. This decrease was due primarily to a change in the structure and pricing of our service contracts that resulted in a change in mix to increasethe volume of one-year duration contracts relative to contracts over one-year in duration. We have a revolving line of credit for $10.0 million with a major lending institution. As of July 3, 2005, there were no outstanding borrowings underthis facility. The line of credit contains a provision for the issuance of letters of credit not to exceed the unused balance of the line. At July 3, 2005, we hadletters of credit totaling $0.8 million. These letters of credit were primarily issued to satisfy requirements of certain of our customers for performance bonds.The line of credit requires us to maintain specified financial covenants related to tangible net worth and liquidity with which we were in compliance as ofJuly 3, 2005. The line of credit expires on January 26, 2006. It is our intention to renew this line of credit when it expires. As part of our business relationship with MCMS, Inc., a former contract manufacturer, we entered into a $9.0 million equipment lease for manufacturingequipment in September 2000 with a third-party financing company; we, in turn, subleased the equipment to MCMS. The equipment lease with the third-party financing company requires us to make monthly payments through September 2005 and to maintain specified financial covenants related toprofitability and our cash to debt ratio with which we were in compliance as of July 3, 2005. The liability related to this lease is included in lease liability onthe consolidated balance sheets. In December 2001, we completed a private placement of $200.0 million of convertible subordinated notes. The notes mature on December 1, 2006.Interest is payable semi-annually at 3.5% per annum. The notes are convertible at the option of the holders into our common stock at an initial conversionprice of $20.96 per share, subject to adjustment. The notes are redeemable in cash at our option, if not converted to common stock prior to the redemptiondate, at an initial redemption price of 101.4% of the principal amount between December 2004 and November 2005; 100.7% of the principal amountbetween December 2005 and November 2006; and 100% thereafter. Each holder of the notes has the right to cause us to repurchase all of such holder’sconvertible notes at 100% of the principal amount plus accrued interest upon a change of control of ownership of Extreme Networks, as defined in theoffering circular. Instead of paying the repurchase price in cash, we may, if we satisfy certain conditions, elect to pay the repurchase price in common stockvalued at 95% of the average of the closing prices of our common stock for the five trading days immediately preceding and including the third trading dayprior to the repurchase date. The following summarizes our contractual obligations (including interest payments) at July 3, 2005, and the effect such obligations are expected tohave on our liquidity and cash flow in future periods (in thousands): Total Less Than1 Year 1 –3 Years 3 –5 Years More Than5 YearsContractual Obligations: Convertible subordinated notes $210,500 $7,000 $203,500 $— $— Non-cancelable inventory purchase commitments 15,090 15,090 — — — Non-cancelable operating lease obligations 33,843 9,438 12,855 7,784 3,766Other non-cancelable purchase commitments 8,000 3,500 4,000 500 — Total contractual cash obligations $267,433 $35,028 $220,355 $8,284 $3,766 We did not have any material commitments for capital expenditures as of July 3, 2005. Other non-cancelable purchase commitments represent OEMand technology agreements. We did not have any off-balance sheet arrangements as of July 3, 2005. We require substantial capital to fund our business, particularly to finance inventories and accounts receivable and for capital expenditures. As a result,we could be required to raise substantial additional capital at any time. To the extent that we raise additional capital through the sale of equity or convertibledebt securities, the issuance of 35Table of Contentssuch securities could result in dilution to existing stockholders. If additional funds are raised through the issuance of debt securities, these securities mayhave rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations. If we areunable to obtain such additional capital, we may be required to reduce the scope of our planned product development and marketing efforts, which wouldhave a material adverse affect our business, financial condition and operating results. We believe that our current cash and cash equivalents, short-term investments, marketable securities and cash available from credit facilities and futureoperations will enable us to meet our working capital requirements for at least the next 12 months. New Accounting Pronouncements Share-Based Payment On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS123(R)”), which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). SFAS 123(R) supersedes APB 25, Accounting forStock Issued to Employees (“APB 25”) and amends SFAS 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approachdescribed in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognizedin the statement of operations based on their fair values. Pro forma disclosure is no longer an alternative. We expect to adopt SFAS 123(R) at the beginning ofour first quarter of fiscal 2006. SFAS 123(R) permits public companies to adopt its requirements using one of two methods: 1) a “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted afterthe effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remainunvested on the effective date: or 2) a “modified retrospective” method, which includes the requirements of the modified prospective method describedabove, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year of adoption. We plan to adopt SFAS 123(R) using the modified-prospective method. We are currently evaluating the requirements of SFAS 123(R) and we have not yet fully determined the impact on our consolidated financialstatements. We believe the impact to our financial statements will result in a material increase in our stock-based employee compensation expenserecognized in our consolidated statements of operations, although it will have no impact on our overall financial position. The stock-based employeecompensation expense presented in our pro forma financial results required to be disclosed under SFAS 123 was $32.2 million, $29.2 million and $24.3million in fiscal 2005, fiscal 2004, and fiscal 2003, respectively. The pro forma stock-based compensation in fiscal 2005 includes approximately $11.4million associated with certain stock option modifications involving vesting accelerations and, as a result, is not indicative of future estimated stock-basedcompensation expense. Additionally, SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows andincrease net financing cash flows in periods after adoption. In March 2005, SEC staff issued Staff Accounting Bulletin (“SAB”) No. 107, Share-Based Payment, which provides guidance on the interactionbetween SFAS No. 123(R) and certain SEC rules and regulations, as well as on the valuation of share-based payments. SAB No. 107 does not modify any ofthe requirements under SFAS No. 123(R). SAB No. 107 provides interpretive guidance related to valuation methods (including assumptions such as expectedvolatility and expected term), first time adoption of SFAS 123(R) in an interim period, the classification of compensation expense and disclosures subsequentto adoption of SFAS No. 123(R). We are currently evaluating the impact of SAB No. 107 on our consolidated financial statements. 36Table of ContentsInventory Costs In November 2004, the FASB issued SFAS 151, Inventory Costs – an amendment of ARB No. 43, Chapter 4, which requires companies to expenseabnormal freight, handling costs, or spoilage in the period incurred and to allocate fixed overhead based on normal capacity, with adjustment if production isabnormally high. This standard becomes effective for the Company on July 1, 2005. We currently account for abnormal freight, handling costs, and spoilageconsistent with this standard. We plan to adopt the provisions on a prospective basis in the first fiscal quarter of 2006. We are currently evaluating the effectsof implementing this standard, however, we do not expect it to have a material impact on our financial position and results of operations. Identification of Impaired Investments In March 2004, the FASB approved the consensus reached on EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments (“EITF 03-1”). EITF 03-1 provides new guidance for evaluating impairment losses on debt and equity investments, aswell as new disclosure requirements for investments that are determined to be other-than-temporarily impaired. In September 2004, the FASB approved theissuance of a FASB Staff Position to delay the requirement to record impairment losses under EITF 03-1. In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment under EITF 03-1. The FASBdirected the staff to issue FASB Staff Position Paper (“FSP”) 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to CertainInvestments (“FSP 115-1”), superseding EITF 03-1. FSP 115-1 will replace the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1 with references to existing other-than-temporary impairment guidance. FSP 115-1 will be effective forother-than-temporary impairment analyses conducted in periods beginning after September 15, 2005. As substantially all of our investments are investment grade government and corporate debt securities that have maturities of less than 3 years, and wehave both the ability and intent to hold the investments until maturity, we do not expect FSP 115-1 to have a material impact on our financial position andresults of operations. Accounting for Income Taxes In December 2004, the FASB issued FSP No. FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deductionon Qualified Production Activities Provided by the American Jobs Creation Act of 2004. On October 22, 2004, the American Jobs Creation Act of 2004 (the“AJCA”) was signed into law. The AJCA provides a new deduction for certain qualified domestic production activities. FSP No. 109-1 is effectiveimmediately and clarifies that such deduction should be accounted for as a special deduction, not as a tax rate reduction, under SFAS No. 109, Accountingfor Income Taxes, no earlier than the year in which the deduction is reported on the tax return. We are currently evaluating whether such deduction may beavailable to us and its impact on our consolidated financial statements. We will recognize the tax benefit of such deductions, if any, beginning in fiscal 2006. In December 2004, the FASB issued FSP No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisionwithin the American Jobs Creation Act of 2004. The AJCA provides a one-time 85% dividends received deduction for certain foreign earnings that arerepatriated under a plan for reinvestment in the United States, provided certain criteria are met. FSP No. 109-2 is effective immediately and providesaccounting and disclosure guidance for the repatriation provision. FSP No. 109-2 allows companies additional time to evaluate the effects of the law on itsunremitted earnings for the purpose of applying the “indefinite reversal criteria” under APB Opinion 23, Accounting for Income Taxes – Special Areas, andrequires explanatory disclosures from companies that have not yet completed the evaluation. We are currently evaluating the effects of the repatriationprovision and their impact on our consolidated financial statements; however, we do not believe that we will benefit from this provision of the AJCA. 37Table of ContentsRisk Factors We Cannot Assure You That We Will Be Profitable in the Future While we have reported a profit in fiscal 2005, we were not profitable in each quarter. In addition, we reported losses for fiscal 2004, fiscal 2003, andfiscal 2002. Fiscal 2000 was the only other year in which we have achieved profitability for the full year. We anticipate continuing to incur significant salesand marketing, product development and general and administrative expenses and, as a result, we will continue to need to manage expense levels andincrease revenue levels to achieve sustained profitability in future quarters. A Number of Factors Could Cause Our Quarterly Financial Results to Be Worse Than Expected, Resulting in a Decline in Our Stock Price Our ability to control our operating expenses at a level that is consistent with anticipated revenue is significant to our financial results. A highpercentage of our expenses are fixed in the short term, so any delay in generating or recognizing revenue could cause our quarterly operating results to fallbelow the expectations of public market analysts or investors, which could cause the price of our stock to fall. Orders in our backlog at the beginning of each quarter do not equal expected revenue for that quarter and are generally cancelable at any time.Accordingly, we are dependent upon obtaining orders during a quarter and shipping those orders in the same quarter to achieve our revenue objectives. Inaddition, the timing of product releases and purchase orders, and product availability, often results in a majority of our product shipments being schedulednear the end of a quarter. Failure to ship these products by the end of a quarter may adversely affect our operating results. Our customer agreements generallyallow customers to delay scheduled delivery dates or to cancel orders within specified timeframes without significant charges to the customers. Furthermore,some of our customers require that we provide installation or inspection services that may delay the recognition of revenue for both products and services,and some of our customer agreements include acceptance provisions that prevent our ability to recognize revenue upon shipment. We may experience a delay in generating or recognizing revenue for a number of reasons and our quarterly revenue and operating results have variedsignificantly in the past and may vary significantly in the future due to a number of factors, including, but not limited to, the following: • changes in general and/or specific economic conditions in the networking industry; • seasonal fluctuations in demand for our products and services, particularly in Asia-Pacific and Europe; • a disproportionate percentage of our sales occurring in the last month of the quarter; • reduced visibility into the implementation cycles for our products and our customers’ spending plans; • our ability to forecast demand for our products, which in the case of lower-than-expected sales, may result in excess or obsolete inventory inaddition to non-cancelable purchase commitments for component parts; • product returns or the cancellation or rescheduling of orders; • our ability to develop, introduce, ship and support new products and product enhancements and manage product transitions; • announcements and new product introductions by our competitors; • our ability to develop and support relationships with enterprise customers, service providers and other potential large customers; • our ability to achieve targeted cost reductions; • fluctuations in warranty or other service expenses actually incurred; 38Table of Contents • our ability to obtain sufficient supplies of sole- or limited-source components for our products on a timely basis; • increases in the prices of the components that we purchase; • decreases in the prices of the products that we sell; • our ability to achieve and maintain desired production volumes and quality levels for our products; • the mix of products sold and the mix of distribution channels through which products are sold; • impairment charges associated with long-lived assets; • restructuring costs associated with adjustments to the size of our operations; • costs relating to possible acquisitions and the integration of technologies or businesses; and • the effect of amortization of deferred compensation and purchased intangibles resulting from existing or new transactions. In the third quarter of fiscal 2005 we, and a number of our competitors, reported revenues below expectations. Our results were particularly impacted bylower sales in Japan compared to the prior quarter, offset in part by increased service revenue and increased product revenue in North America and Europe.We believe that revenues will increase in coming quarters; however, our future results could be adversely affected if longer term economic or industry trendsare unfavorable. Due to the foregoing factors, we believe that period-to-period comparisons of our operating results should not be relied upon as an indicator of ourfuture performance. Intense Competition in the Market for Networking Equipment Could Prevent Us from Increasing Revenue and Returning to Profitability The market for networking equipment is intensely competitive. Our principal competitors include Cisco Systems, Enterasys Networks, FoundryNetworks, Inc., Nortel Networks and 3Com Corporation. In addition, a number of private companies and foreign competitors have announced plans for newproducts, or have introduced products, that may compete with our own products. Some of our current and potential competitors have superior marketleverage, longer operating histories and substantially greater financial, technical, sales and marketing resources, in addition to wider name recognition andlarger installed customer bases. Foreign competitors may have competitive advantages due to significantly lower costs or strong ties to customers in theirhome countries. These competitors may have developed, or may in the future develop, new competing products based on technologies that compete with ourown products or render our products obsolete. Furthermore, a number of these competitors may merge or form strategic partnerships that enable them to offeror bring to market competitive products. Consolidation within our industry could lead to increased competition and could harm our operating results. The pricing policies of our competitors impact the overall demand for our products and services. Some of our competitors are capable of operating atsignificant losses for extended periods of time, increasing pricing pressure on our products and services. If we do not maintain competitive pricing, thedemand for our products and services, as well as our market share, may decline. From time to time, we may lower the prices of our products and services.When this happens, if we are unable to reduce our component costs or improve operating efficiencies, our revenues and margins will be adversely affected. To remain competitive, we believe that we must, among other things, invest significant resources in developing new products, improve our currentproducts and maintain customer satisfaction. Such investment will increase our expenses and affect our profitability. In addition, if we fail to make thisinvestment, we may not be able to compete successfully with our competitors, which could have a material adverse effect on our revenue and futureprofitability. 39Table of ContentsWhen Our Products Contain Undetected Software or Hardware Errors, We Incur Significant Unexpected Expenses and Could Lose Sales Network products frequently contain undetected software or hardware errors when new products or new versions or updates of existing products arereleased to the marketplace. In the past, we have experienced such errors in connection with new products and product upgrades. We have experiencedcomponent problems that caused us to incur higher than expected warranty and service costs and expenses, and to record an accrual for related anticipatedexpenses. We have undertaken extensive efforts to address these issues; however, until these programs are completed, these expenses are expected to exceednormal levels. In the future, we expect that, from time to time, such errors or component failures will be found in new or existing products after thecommencement of commercial shipments. These problems may have a material adverse effect on our business by causing us to incur significant warranty andrepair costs, diverting the attention of our engineering personnel from new product development efforts, delaying the recognition of revenue and causingsignificant customer relations problems. Further, if products are not accepted by customers due to such defects, and such returns exceed the amount weaccrued for defect returns based on our historical experience, our operating results would be adversely affected. Our products must successfully interoperate with products from other vendors. As a result, when problems occur in a network, it may be difficult toidentify the sources of these problems. The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or lossof market acceptance of our products and any necessary revisions may cause us to incur significant expenses. The occurrence of any such problems wouldlikely have a material adverse effect on our business, operating results and financial condition. We Depend Upon International Sales for a Significant Portion of Our Revenue and Our Ability to Grow Our International Sales Depends onSuccessfully Expanding Our International Operations International sales constitute a significant portion of our net revenues. Our ability to grow will depend in part on the continued expansion ofinternational sales. Sales to customers outside of the United States accounted for approximately 56%, 61%, and 60% of our net revenues for fiscal 2005, fiscal2004, and fiscal 2003, respectively. Our international sales primarily depend on the success of our resellers and distributors. The failure of these resellers anddistributors to sell our products internationally would limit our ability to sustain and grow our revenue. There are a number of risks arising from ourinternational business, including: • longer accounts receivable collection cycles; • difficulties in managing operations across disparate geographic areas; • difficulties associated with enforcing agreements through foreign legal systems; • the payment of operating expenses in local currencies, which exposes us to risks of currency fluctuations; • higher credit risks requiring cash in advance or letters of credit; • difficulty in safeguarding intellectual property; • political and economic turbulence; • potential adverse tax consequences; and • unexpected changes in regulatory requirements, including compliance with U.S. and foreign export laws and regulations. In addition, conducting our business on a global basis subjects us to a number of frequently changing and complex trade protection measures andimport or export regulatory requirements. Our failure to comply with these measures and regulatory requirements may result in the imposition of financialpenalties and restrictions on our ability to conduct business in and with certain countries, which may harm our business and damage our reputation. Pursuantto regulations of the U.S. Department of Commerce providing for voluntary disclosure, in 40Table of Contentsthe fourth quarter of fiscal 2002, we disclosed information regarding a possible violation of certain export regulations. The Department of Commerce hascompleted an investigation of these transactions, but has not yet advised us of the action, if any, that it proposes to take in this matter. We intend to workwith the Department to resolve the matter. While it is possible that the Department will seek civil penalties and/or other administrative sanctions, we believethat these matters will be resolved without a material adverse effect on our business. We have also implemented procedures to reduce the risk of violations inthe future. Our international sales currently are U.S. dollar-denominated. Recently, the U.S. dollar exchange rate has fallen against foreign currencies, in particularthe Euro. However, future increases in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in internationalmarkets. In the future, we may elect to invoice some of our international customers in local currency, which will expose us to fluctuations in exchange ratesbetween the U.S. dollar and the particular local currency. If we do so, we may decide to engage in hedging transactions to minimize the risk of suchfluctuations. We have entered into foreign exchange forward contracts to offset the impact of payment of operating expenses in local currencies to some of ouroperating foreign subsidiaries. However, if we are not successful in managing these hedging transactions, we could incur losses from hedging activities. We Expect the Average Selling Prices of Our Products to Decrease, Which May Reduce Gross Margin and/or Revenue The network equipment industry has traditionally experienced a rapid erosion of average selling prices due to a number of factors, includingcompetitive pricing pressures, promotional pricing and technological progress. We anticipate that the average selling prices of our products will decrease inthe future in response to competitive pricing pressures, excess inventories, increased sales discounts and new product introductions by us or our competitors,including, for example, competitive products manufactured with low-cost merchant silicon. We may experience substantial decreases in future operatingresults due to the erosion of our average selling prices. To maintain our gross margin, we must develop and introduce on a timely basis new products andproduct enhancements and continually reduce our product costs. Our failure to do so would likely cause our revenue and gross margins to decline, whichcould have a material adverse effect on our operating results and cause the price of our common stock to decline. Some of Our Customers May Not Have the Resources to Pay for Our Products as a Result of the Current Economic Environment At July 3, 2005, no customer accounted for more than 10% of our accounts receivable balance. Some of our customers are likely to experience seriouscash flow problems and, as a result, may find it difficult to obtain financing, if financing is available at all. If our customers are not successful in generatingsufficient revenue or securing alternate financing arrangements, they may not be able to pay, or may delay payment of, the amounts that they owe us. In thefourth quarter of fiscal 2005, one large distributor in Europe became delinquent in its payments to us due to cash flow problems and difficulty in obtainingfinancing. Although, this customer has committed to honor its obligations to us, we increased our receivable allowance to cover a higher percentage of thiscustomer’s outstanding balance. However, a complete default in payment by this customer would have an adverse affect on our results of operations andfinancial position. In addition, sales to the service provider market are especially volatile and continued declines or delays in sale orders from this market may harm ourfinancial condition. Furthermore, they may not order as many products from us as originally forecast, or cancel orders with us entirely. The inability of someof our potential customers to pay us for our products may adversely affect our cash flow, the timing of our revenue recognition and the amount of revenue,which may cause our stock price to decline. 41Table of ContentsThe Market in Which We Compete is Subject to Rapid Technological Progress and to Compete We Must Continually Introduce New Products thatAchieve Broad Market Acceptance The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirementsand evolving industry standards. If we do not regularly introduce new products in this dynamic environment, our product lines will become obsolete.Developments in routers and routing software could also significantly reduce demand for our products. Alternative technologies could achieve widespreadmarket acceptance and displace the Ethernet technology on which we have based our product architecture. We cannot assure you that our technologicalapproach will achieve broad market acceptance or that other technologies or devices will not supplant our own products and technology. When we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products,customers may defer or cancel orders for our existing products. These actions could have a material adverse effect on our operating results by unexpectedlydecreasing sales, increasing inventory levels of older products and exposing us to greater risk of product obsolescence. The market for switching products isevolving and we believe our ability to compete successfully in this market is dependent upon the continued compatibility and interoperability of ourproducts with products and architectures offered by other vendors. In particular, the networking industry has been characterized by the successive introduction of new technologies or standards that have dramaticallyreduced the price and increased the performance of switching equipment. To remain competitive, we need to introduce products in a timely manner thatincorporate, or are compatible with, these emerging technologies. We are particularly dependent upon the successful introduction of new products. Wecannot ensure that any new products we introduce will be commercially successful. We have experienced delays in releasing new products and productenhancements in the past that resulted in lower quarterly revenue than anticipated. We may experience similar delays in product development and releases inthe future, and any delay in product introduction could adversely affect our ability to compete, causing our operating results to be below our expectations orthe expectations of public market analysts or investors. Our Limited Ability to Protect Our Intellectual Property May Adversely Affect Our Ability to Compete We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.However, we cannot ensure that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independentlydevelop similar or competing products that do not infringe on our patents. We generally enter into confidentiality or license agreements with our employees,consultants and corporate partners, and control access to and distribution of our software, documentation and other proprietary information. Despite ourefforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology, whichwould adversely affect our ability to compete. Claims of Infringement by Others May Increase and the Resolution of such Claims May Adversely Affect our Ability to Compete and Our OperatingResults Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and otherintellectual property rights. Because of the existence of a large number of patents in the networking field, the secrecy of some pending patents and theissuance of new patents as a rapid pace, it is not possible to determine in advance if a product or component might infringe the patent rights of others.Because of the potential for courts awarding substantial damages and the lack of predictability of such awards, it is not uncommon for companies in our andsimilar industries to settle even potentially unmeritorious claims for very substantial amounts. We expect to increasingly be subject to infringement claimsasserted by third parties as the numbers of products and competitors in the market for network switches grow and product functionality overlaps. 42Table of ContentsWe are actively involved in disputes and licensing discussions with, and have received notices from, others regarding their claimed proprietary rights.As the functionality and features of our products expands, these disputes and discussions could increase or become harder to resolve. The corporations withwhom we have or could have disputes or discussions include corporations with extensive patent portfolios and substantial financial assets who are activelyengaged in programs to generate substantial revenues from their patent portfolios, and who are seeking or may seek significant payments or royalties from usand others in our industry. We cannot ensure that we will always be able successfully to defend ourselves against such claims or conclude licensingdiscussions on favorable terms. If we are found to infringe the proprietary rights of others, or if we otherwise settle such claims or enter into licensingarrangement to resolve potential disputes, we could be compelled to pay damages, royalties or other payments and either obtain a license to those intellectualproperty rights or alter our products so that they no longer infringe upon such proprietary rights. Any license could be very expensive to obtain or may not beavailable at all. Similarly, changing our products or processes to avoid infringing the rights of others may be costly or impractical. Litigation resulting fromclaims that we are infringing the proprietary rights of others has resulted and could in the future result in substantial costs and a diversion of resources, andcould have a material adverse effect on our business, financial condition and results of operations. Due to the number of companies with extensive patentportfolios in our industry who are or may be actively involved in licensing programs, we believe that even if we do not infringe any patents, we will incursignificant expenses in the future due to disputes or licensing negotiations, though the amounts can not be determined. We cannot assure you that any suchexpenses will not be material or otherwise adversely affect our operating results. We Are Engaged in Litigation Regarding Intellectual Property Rights, and an Adverse Outcome Could Harm Our Business and Require Us to IncurSignificant Costs We have received notice from several companies alleging that we may be infringing their patents. One of these companies, Lucent Technologies, Inc.,filed a claim against us alleging patent infringement, and although we received a favorable verdict in the first phase of the trial, the judge granted Lucent’spost-trial motion for a new trial, and we continue in litigation. Another company, Enterasys Networks, Inc., also recently filed a claim against us allegingpatent infringement. We are evaluating the merits of the claim and potential counter claims. Without regard to the merits of this or any other claim, ifjudgments by a court of law on this or any other claim received in the future were to be upheld, or if we were otherwise to agree to the settlement of suchclaims, the consequences to us may be severe and could require us, among other actions to: • stop selling our products that incorporate the challenged intellectual property; • obtain a royalty bearing license to sell or use the relevant technology, which license may not be available on reasonable terms or available at all; • pay damages; or • redesign those products that use the disputed technology. If we are compelled to take any of the foregoing actions, our business could be severely harmed. Adjustments to the Size of Our Operations May Require Us to Incur Unanticipated Costs Prior to the quarter ended April 1, 2001, we experienced rapid growth and expansion that placed a significant strain on our resources. Subsequent tothat period, we have from time to time incurred unanticipated costs to downsize our operations to a level consistent with lower forecasted sales. We may makemistakes in structuring or operating our business, such as inaccurate sales forecasting or incorrect material planning. Any of these mistakes may lead tounanticipated fluctuations in our operating results. We cannot assure you that we will be able to size our operations in accordance with fluctuations of ourbusiness in the future. 43Table of ContentsWe Must Continue to Develop and Increase the Productivity of Our Indirect Distribution Channels to Increase Net Revenues and Improve OurOperating Results Our distribution strategy focuses primarily on developing and increasing the productivity of our indirect distribution channels. If we fail to developand cultivate relationships with significant resellers, or if these resellers are not successful in their sales efforts, sales of our products may decrease and ouroperating results could suffer. Many of our resellers also sell products from other vendors that compete with our products. We cannot assure you that we willbe able to enter into additional reseller and/or distribution agreements or that we will be able to successfully manage our product sales channels. Our failureto do any of these could limit our ability to grow or sustain revenue. In addition, our operating results will likely fluctuate significantly depending on thetiming and amount of orders from our resellers. We cannot assure you that our resellers and/or distributors will continue to market or sell our productseffectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. Most of Our Revenue is Derived From Sales of Three Product Families, So We are Dependent on Widespread Market Acceptance of These Products We derive substantially all of our revenue from sales of our Summit, BlackDiamond and Alpine products and related services. We expect that revenuefrom these product families will account for a substantial portion of our revenue for the foreseeable future. Accordingly, widespread market acceptance of ourproduct families is vital to our future success. Factors that may affect the sales of our products, some of which are beyond our control, include: • the demand for switching products (Gigabit Ethernet and Layer 3 switching technologies in particular) in the enterprise and service providermarkets; • the performance, price and total cost of ownership of our products; • the availability and price of competing products and technologies; • our ability to match supply with demand for certain products; and • the success and development of our resellers, distributors and field sales channels. We may not be able to achieve widespread market acceptance of our product families, which could reduce our revenue. Future Performance will Depend on the Introduction and Acceptance of New Products Our future performance will also depend on the successful development, introduction, and market acceptance of new and enhanced products thataddress customer requirements in a timely and cost-effective manner. In particular, we are dependent upon the successful introduction of new products. In thepast, we have experienced delays in product development and such delays may occur in the future. We have recently announced a number of new orenhanced products. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. Therefore, to theextent customers defer or cancel orders in the expectation of new product releases, any delay in the development or introduction of new products could causeour operating results to suffer. The inability to achieve and maintain widespread levels of market acceptance for our current and future products maysignificantly impair our revenue growth. Our Reliance on Industry Standards, Technological Change in the Marketplace and New Product Initiatives May Cause our Sales to Fluctuate orDecline The network equipment industry in which we compete is characterized by rapid changes in technology and customers requirements and evolvingindustry standards. As a result, our success depends on • the timely adoption and market acceptance of industry standards, and timely resolution of conflicting U.S. and international industry standards;and • our ability to influence the development of emerging industry standards and to introduce new and enhanced products that are compatible withsuch standards. 44Table of ContentsSlow market acceptance of new technologies, products or industry standards could adversely affect our sales or overall results of operations. Inaddition, if our technology is not included in an industry standard on a timely basis or if we fail to achieve timely certification of compliance to industrystandards for our products, our sales of such products or our results of operations could be adversely affected. If a Key Reseller, Distributor, or Other Significant Customer Cancels or Delays a Large Purchase, Our Net Revenues May Decline and the Price of OurStock May Fall To date, a limited number of resellers, distributors and other customers have accounted for a significant portion of our revenue. One distributor, TechData, accounted for 11% of our net revenues in fiscal 2005 and fiscal 2003. No distributor or customer accounted for more than 10% of our net revenues infiscal 2004. In addition, while no other distributor or customer has accounted for 10% or more of revenue in the recent fiscal years, sales to severaldistributors represent a high percentage of our sales. If any of our large customers stop or delay purchases, our revenue and profitability would be adverselyaffected. Our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, so a substantial reduction ordelay in sales of our products to a significant reseller, distributor or other customer could harm our business, operating results and financial condition.Although our largest customers may differ from period-to-period, we anticipate that our operating results for any given period will continue to depend to asignificant extent on large orders from a relatively small number of customers. While our financial performance depends on large orders from a limited number of key resellers, distributors and other significant customers, we do nothave binding purchase commitments from any of them. For example: • our service providers and enterprise customers can stop purchasing, and our resellers and distributors can stop marketing, our products at any time; • our reseller agreements are non-exclusive and are for one-year terms, with no obligation upon the resellers to renew the agreements; and • our reseller, distributor and end-user customer agreements generally do not require minimum purchases. Under specified conditions, some third-party distributors are allowed to return products to us. We do not recognize revenue on sales to distributorsuntil the distributors sell the product to their customers. The Sales Cycle for Our Products is Long and We May Incur Substantial Non-Recoverable Expenses or Devote Significant Resources to Sales that DoNot Occur When Anticipated The use of indirect sales channels may contribute to the length and variability of our sales cycle. Our products represent a significant strategic decisionby a customer regarding its communications infrastructure. The decision by customers to purchase our products is often based on the results of a variety ofinternal procedures associated with the evaluation, testing, implementation and acceptance of new technologies. Accordingly, the product evaluation processfrequently results in a lengthy sales cycle, typically ranging from three months to longer than a year, and as a result, our ability to sell products is subject to anumber of significant risks, including: • the risk that budgetary constraints and internal acceptance reviews by customers will result in the loss of potential sales; • the risk of substantial variation in the length of the sales cycle from customer to customer, making decisions on the expenditure of resourcesdifficult to assess; • the risk that we may incur substantial sales and marketing expenses and expend significant management time in an attempt to initiate or increasethe sale of products to customers, but not succeed; 45Table of Contents • the risk that, if a sales forecast from a specific customer for a particular quarter is not achieved in that quarter, we may be unable to compensate forthe shortfall, which could harm our operating results; and • the risk that downward pricing pressures could occur during this lengthy sales cycle. We Purchase Several Key Components for Products From Single or Limited Sources and Could Lose Sales if These Suppliers Fail to Meet Our Needs We currently purchase several key components used in the manufacture of our products from single or limited sources and are dependent upon supplyfrom these sources to meet our needs. Certain components such as tantalum capacitors, static random access memory, or SRAM, dynamic random accessmemory, or DRAM, and printed circuit boards, have been in the past, and may in the future be, in short supply. We have encountered, and are likely in thefuture to encounter, shortages and delays in obtaining these or other components, and this could have a material adverse effect on our ability to meetcustomer orders. Our principal sole-source components include: • ASICs; • microprocessors; • programmable integrated circuits; • selected other integrated circuits; • custom power supplies; and • custom-tooled sheet metal. Our principal limited-source components include: • flash memories; • DRAMs and SRAMs; and • printed circuit boards. We use our forecast of expected demand to determine our material requirements. Lead times for materials and components we order vary significantly,and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. If forecasts exceed orders, we may haveexcess and/or obsolete inventory on hand or under non-cancelable purchase commitments that could have a material adverse effect on our operating resultsand financial condition. If orders exceed forecasts, we may have inadequate supplies of certain materials and components, which could have a materialadverse effect on our operating results and financial condition. We do not have agreements fixing long-term prices or minimum volume requirements fromsuppliers. From time to time we have experienced shortages and allocations of certain components, resulting in delays in filling orders. Qualifying newsuppliers to compensate for such shortages may be time-consuming and costly, and may increase the likelihood of errors in design or production. In addition,during the development of our products, we have experienced delays in the prototyping of our chipsets, which in turn has led to delays in productintroductions. We cannot ensure that similar delays will not occur in the future. Furthermore, we cannot ensure that the performance of the components asincorporated in our products will meet the quality requirements of our customers. Our Dependence on One Contract Manufacturer for All of Our Manufacturing Requirements Could Harm Our Operating Results If the demand for our products grows, we will need to increase our material purchases, contract manufacturing capacity, and internal test and qualityfunctions. Any disruptions in product flow could limit our revenue, adversely affect our competitive position and reputation, and result in additional costs orcancellation of orders under agreements with our customers. 46Table of ContentsWe rely on one independent contractor, Flextronics International, Ltd., to manufacture our products. This company’s facilities are located in San Jose,California and Guadalajara, Mexico. Our commitment with Flextronics is formalized through a one-year contract. We have experienced delays in productshipments from contract manufacturers in the past, which in turn delayed product shipments to our customers. These or similar problems may arise in thefuture, such as products of inferior quality, insufficient quantity of products, or the interruption or discontinuance of operations of a manufacturer, any ofwhich could have a material adverse effect on our business and operating results. We do not know whether we will effectively manage our contract manufacturer or that this manufacturer will meet our future requirements for timelydelivery of products of sufficient quality and quantity. We intend to introduce new products and product enhancements, which will require that we rapidlyachieve volume production by coordinating our efforts with those of our suppliers and contract manufacturer. The inability of our contract manufacturer toprovide us with adequate supplies of high-quality products may cause a delay in our ability to fulfill orders and may have a material adverse effect on ourbusiness, operating results and financial condition. Moreover, our current dependence on a single manufacturer makes us particularly vulnerable to theserisks. As part of our cost-reduction efforts, we will need to realize lower per unit product costs from our contract manufacturer by means of volumeefficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such price reductions will occur.The failure to obtain such price reductions would adversely affect our gross margins and operating results. If We Do Not Adequately Manage and Evolve Our Financial Reporting and Managerial Systems and Processes, Our Ability to Manage and Grow OurBusiness May Be Harmed Our ability to successfully implement our business plan and comply with regulations requires an effective planning and management process. We needto continue improving our existing, and implement new, operational and financial systems, procedures and controls. Any delay in the implementation of, ordisruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to record and report financial and managementinformation on a timely and accurate basis, or to forecast future results. If, In The Future, We Are Unable To Favorably Assess The Effectiveness Of Our Internal Control Over Financial Reporting, or If Our IndependentRegistered Public Accounting Firm Is Unable To Provide An Unqualified Attestation Report On Our Assessment, Our Stock Price Could Be AdverselyAffected. Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our independent registered public accounting firm to attestto, the effectiveness of our internal control over financial reporting. We have an ongoing program to perform the system and process evaluation and testingnecessary to comply with these requirements. We expect to incur significant expenses and dedicate significant management resources towards Section 404compliance on an ongoing basis. In the event that our executive officers or independent registered public accounting firm determine in the future that ourinternal controls over financial reporting are not effective as defined under Section 404, investor confidence and our stock price could be adversely affected. Future Changes in Financial Accounting Standards May Cause Adverse Unexpected Revenue Fluctuations and Affect Our Reported Results ofOperations A change in accounting policies can have a significant effect on our reported results and may even affect our reporting of transactions completedbefore the change is effective. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in thefuture. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct ourbusiness. In particular, in December 2004 the Financial Accounting Standards Board issued a statement requiring companies to record stock option grants ascompensation expense in their income statements. This statement is effective beginning with our first quarter of fiscal 2006. The current methodology forexpensing such stock 47Table of Contentsoptions is based on, among other things, the historical volatility of the underlying stock and the expected life of our stock options. Our stock price has beenhistorically volatile. Therefore, the adoption this accounting standard will negatively impact our profitability and may adversely impact our stock price. Inaddition, the adoption of such standard could limit our ability to continue to use stock options as an incentive and retention tool, which could, in turn, hurtour ability to recruit employees and retain existing employees. In addition, various accounting rules and regulations have been established over the recent past relating to revenue recognition. These regulationsfrequently require judgments in their application, and are subject to numerous subsequent clarifications and interpretations, some of which may requirechanges in the way we recognize revenue and may require restatement of prior period revenue and results, either of which could adversely affect our reportedresults. Our Business Substantially Depends Upon the Continued Growth of the Internet and Internet-Based Systems A substantial portion of our business and revenue depends on growth of the Internet and on the deployment of our products by customers that dependon the continued growth of the Internet. As a result of the recent economic slowdown and reduction in capital spending, which have particularly affectedtelecommunications service providers, spending on Internet infrastructure has declined, which has materially harmed our business. To the extent that therecent economic slowdown and reduction in capital spending continue to adversely affect spending on Internet infrastructure, we could continue toexperience material harm to our business, operating results, and financial condition. Because of the rapid introduction of new products, and changing customer requirements related to matters such as cost-effectiveness and security, webelieve that there could be certain performance problems with Internet communications in the future, which could receive a high degree of publicity andvisibility. As we are a large supplier of networking products, our business, operating results, and financial condition may be materially adversely affected,regardless of whether or not these problems are due to the performance of our own products. Such an event could also result in a material adverse effect on themarket price of our common stock independent of direct effects on our business. Compliance with Changing Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SECregulations and NASDAQ Stock Market rules, are creating uncertainty for companies such as ours. We are committed to maintaining high standards ofcorporate governance and public disclosure. As a result, we are investing all reasonably necessary resources to comply with evolving standards, and thisinvestment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activitiesto compliance activities. We Have Been Named as a Defendant in a Shareholder Class Action Lawsuit Arising Out of Our Public Offerings of Securities in 1999 Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint is brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8, 1999through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and 48Table of ContentsOctober 1999 secondary offering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice.The complaint alleges liability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934,on the grounds that the registration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchaseshares in the offerings in exchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchaseadditional shares in the aftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to thesecondary offering only. The amended complaint also alleges that false analyst reports were issued. No specific damages are claimed. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims underSection 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. We have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will notbe required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of theinsurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured. If thesettlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on ourconsolidated financial position, results of operations and cash flows in the future. In addition, we may become subject to other types of litigation in the future. Litigation is often expensive and diverts management’s attention andresources, which could materially and adversely affect our business. Our Headquarters and Some Significant Supporting Businesses Are Located in Northern California and Other Areas Subject to Natural Disasters andActs of Terrorism That Could Disrupt Our Operations and Harm Our Business Our corporate headquarters are located in Silicon Valley in Northern California. Historically, this region has been vulnerable to natural disasters andother risks, such as earthquakes, fires and floods, which at times have disrupted the local economy and posed physical risks to our property. We have acontract manufacturer located in Northern California and in Mexico where similar natural disasters and other risks may disrupt the local economy and posephysical risks to our property and the property of our contract manufacturer. In addition, the continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, maycause further disruptions to the economies of the U.S. and other countries. If such disruptions result in delays or cancellations of customer orders for ourproducts, our business and operating results will suffer. We currently do not have redundant, multiple site capacity in the event of a natural disaster, terrorist act or other catastrophic event. In the event ofsuch an occurrence, our business would suffer. 49Table of ContentsIf We Lose Key Personnel or are Unable to Hire Additional Qualified Personnel as Necessary, We May Not Be Able to Successfully Manage OurBusiness or Achieve Our Goals Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, service andoperations personnel, many of whom would be difficult to replace. We do not have employment contracts with these individuals nor do we carry lifeinsurance on any of our key personnel. We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales andmarketing, service, finance and operations personnel. The market for these personnel is competitive, especially in the San Francisco Bay Area, and we havehad difficulty in hiring employees, particularly engineers, in the timeframe we desire. In addition, retention has become more difficult for us and other publictechnology companies as a result of the stock market decline, which caused the price of many of our employees’ stock options to be above the current marketprice of our stock and we have recently experienced a high level of attrition. There can be no assurance that we will be successful in attracting and retainingour key personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiringdesired personnel, particularly engineers and sales personnel, could make it difficult for us to manage our business and meet key objectives, such as newproduct introductions. In addition, companies in the networking industry whose employees accept positions with competitors frequently claim thatcompetitors have engaged in unfair hiring practices. We have from time to time been involved in claims like this with other companies and, although to datethey have not resulted in material litigation, we do not know whether we will be involved in additional claims in the future as we seek to hire and retainqualified personnel or that such claims will not result in material litigation. We could incur substantial costs in litigating any such claims, regardless of themerits. Failure of Our Products to Comply With Evolving Industry Standards and Complex Government Regulations May Cause Our Products to Not BeWidely Accepted, Which May Prevent Us From Growing Our Net Revenues or Achieving Profitability on a Fiscal Year Basis The market for network equipment products is characterized by the need to support industry standards as different standards emerge, evolve andachieve acceptance. We will not be competitive unless we continually introduce new products and product enhancements that meet these emergingstandards. In the past, we have introduced new products that were not compatible with certain technological standards, and in the future we may not be ableto effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Ourproducts must comply with various United States federal government regulations and standards defined by agencies such as the Federal CommunicationsCommission, in addition to standards established by governmental authorities in various foreign countries and recommendations of the InternationalTelecommunication Union. If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatoryapprovals or certificates we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our netrevenue or achieving profitability on a fiscal year basis. Production and marketing of products in certain states and countries may subject us to environmental and other regulations including, in someinstances, the requirement to provide customers the ability to return product at the end of its useful life, and place the responsibility for environmentally safedisposal or recycling with us. Additionally, certain states and countries may pass regulations requiring our products to meet certain requirements to useenvironmentally friendly components. Such laws and regulations have recently been passed in several jurisdictions in which we operate, including theEuropean Union which issued a Directive 2002/96/EC Waste Electrical and Electronic Equipment (“WEEE”) to mandate funding, collection, treatment,recycling and recovery of WEEE by producers of electrical or electronic equipment into Europe. China is in the final approval stage of compliance programswhich will harmonize with the European Union WEEE and RoHS directives. In the future, Japan and other countries are expected to adopt environmentalcompliance programs. If we fail to comply with these regulations, we may not be able to sell our products in jurisdictions where these regulations apply,which would have a material adverse affect on our results of operations. 50Table of ContentsFailure to Successfully Expand Our Sales and Support Teams or Educate Them In Regard to Technologies and Our Product Families May Harm OurOperating Results The sale of our products and services requires a concerted effort that is frequently targeted at several levels within a prospective customer’sorganization. We may not be able to increase net revenues unless we expand our sales and support teams in order to address all of the customer requirementsnecessary to sell our products. We cannot assure you that we will be able to successfully integrate employees into our company or to educate current and future employees in regardto rapidly evolving technologies and our product families. A failure to do so may hurt our revenue growth and operating results. We May Engage in Future Acquisitions that Dilute the Ownership Interests of Our Stockholders, Cause Us to Incur Debt and Assume ContingentLiabilities As part of our business strategy, we review acquisition and strategic investment prospects that we believe would complement our current productofferings, augment our market coverage or enhance our technical capabilities, or otherwise offer growth opportunities. From time to time we reviewinvestments in new businesses and we expect to make investments in, and to acquire, businesses, products, or technologies in the future. In the event of anyfuture acquisitions, we could: • issue equity securities which would dilute current stockholders’ percentage ownership; • incur substantial debt; • assume contingent liabilities; or • expend significant cash. These actions could have a material adverse effect on our operating results or the price of our common stock. Moreover, even if we do obtain benefitsin the form of increased sales and earnings, there may be a lag between the time when the expenses associated with an acquisition are incurred and the timewhen we recognize such benefits. This is particularly relevant in cases where it is necessary to integrate new types of technology into our existing portfolioand new types of products may be targeted for potential customers with which we do not have pre-existing relationships. Acquisitions and investmentactivities also entail numerous risks, including: • difficulties in the assimilation of acquired operations, technologies and/or products; • unanticipated costs associated with the acquisition or investment transaction; • the diversion of management’s attention from other business concerns; • adverse effects on existing business relationships with suppliers and customers; • risks associated with entering markets in which we have no or limited prior experience; • the potential loss of key employees of acquired organizations; and • substantial charges for the amortization of certain purchased intangible assets, deferred stock compensation or similar items. We cannot ensure that we will be able to successfully integrate any businesses, products, technologies, or personnel that we might acquire in the future,and our failure to do so could have a material adverse effect on our business, operating results and financial condition. We May Need Additional Capital to Fund Our Future Operations and, If It Is Not Available When Needed, We May Need to Reduce Our PlannedDevelopment and Marketing Efforts, Which May Reduce Our Net Revenues and Prevent Us From Achieving Profitability on a Fiscal Year Basis We believe that our existing working capital and cash available from credit facilities and future operations, will enable us to meet our working capitalrequirements for at least the next 12 months. However, if cash from 51Table of Contentsfuture operations is insufficient, or if cash is used for acquisitions or other currently unanticipated uses, we may need additional capital. The developmentand marketing of new products and the expansion of reseller and distribution channels and associated support personnel requires a significant commitment ofresources. In addition, if the markets for our products develop more slowly than anticipated, or if we fail to establish significant market share and achievesufficient net revenues, we may continue to consume significant amounts of capital. As a result, we could be required to raise additional capital. To the extentthat we raise additional capital through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution of the sharesheld by existing stockholders. If additional funds are raised through the issuance of debt securities, such securities may provide the holders certain rights,preferences, and privileges senior to those of common stockholders, and the terms of such debt could impose restrictions on our operations. We cannot assureyou that additional capital, if required, will be available on acceptable terms, or at all. If we are unable to obtain sufficient amounts of additional capital, wemay be required to reduce the scope of our planned product development and marketing efforts, which could harm our business, financial condition andoperating results. We Have Substantial Debt Obligations In connection with the sale of convertible subordinated notes in December 2001, we incurred $200 million of indebtedness. The convertiblesubordinated notes are scheduled for repayment in December 2006. We will require substantial amounts of cash to fund scheduled payments of interest on theconvertible notes, payment of the principal amount of the convertible notes, future capital expenditures, payments on our leases and any increased workingcapital requirements. If we are unable to meet our cash requirements out of cash flow from operations, there can be no assurance that we will be able to obtainalternative financing. The degree to which we are financially leveraged could materially and adversely affect our ability to obtain financing for workingcapital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. In the absence of such financing,our ability to respond to changing business and economic conditions, to make future acquisitions, to absorb adverse operating results or to fund capitalexpenditures or increased working capital requirements would be significantly reduced. Our ability to meet our debt service obligations will be dependentupon our future performance, which will be subject to financial, business and other factors affecting our operations, some of which are beyond our control. Ifwe do not generate sufficient cash flow from operations to repay the notes at maturity, we could attempt to refinance the notes; however, no assurance can begiven that such a refinancing would be available on terms acceptable to us, if at all. Any failure by us to satisfy our obligations with respect to the notes atmaturity (with respect to payments of principal) or prior thereto (with respect to payments of interest or required repurchases) would constitute a default underthe indenture and could cause a default under agreements governing our other indebtedness. We Have Entered into Long-Term Lease Agreements for Several Facilities that are Currently Vacant and May be Difficult to Sublease due to CurrentReal Estate Market Conditions We have certain long-term real estate lease commitments carrying future obligations for non-cancelable lease payments. Reductions in our workforceand the restructuring of operations since fiscal 2002 have resulted in the need to consolidate certain of these leased facilities, located primarily in NorthernCalifornia, for which we recorded excess facilities charges of approximately $6.5 million in fiscal 2004, and $9.6 million in fiscal 2003. For moreinformation, see Note 12 of Notes to Consolidated Financial Statements. We continue to attempt to sublease certain of these facilities and have estimated theamount of sublease income to offset the carrying costs of these facilities when establishing our excess facilities charges. However, we may not be able tosublease these facilities at the times or on the terms we anticipated when we took the excess facilities charge and therefore if the market does not improve, wemay incur additional charges in the future. In addition, we may incur additional charges for excess facilities as a result of additional reductions in ourworkforce or future restructuring of operations. We will continue to be responsible for all carrying costs of these facilities until such time as we can subleasethese facilities or terminate the applicable leases based on the contractual terms of the lease agreements, and these costs may have an adverse effect on ourbusiness, operating results and financial condition. 52Table of ContentsOur Stock Price Has Been Volatile In the Past and Our Stock Price and the Price of the Notes May Significantly Fluctuate in the Future In the past, our common stock price has fluctuated significantly. This could continue as we or our competitors announce new products, our results orthose of our customers or competition fluctuate, conditions in the networking or semiconductor industry change, or when investors, change their sentimenttoward stocks in the networking technology sector. In addition, fluctuations in our stock price and our price-to-earnings multiple may make our stock attractive to momentum, hedge or day-tradinginvestors who often shift funds into and out of stock rapidly, exacerbating price fluctuations in either direction, particularly when viewed on a quarterlybasis. Securities We Issue to Fund Our Operations Could Dilute Your Ownership We may decide to raise additional funds through public or private debt or equity financing to fund our operations. If we raise funds by issuing equitysecurities, the percentage ownership of current stockholders will be reduced and the new equity securities may have rights prior to those of our commonstock, including the common stock issuable upon conversion of the notes. We may not obtain sufficient financing on terms that are favorable to you or us.We may delay, limit or eliminate some or all of our proposed operations if adequate funds are not available. Provisions in Our Charter Documents and Delaware Law and Our Adoption of a Stockholder Rights Plan May Delay or Prevent Acquisition OfExtreme, Which Could Decrease the Value of Our Common Stock and the Notes Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us withoutthe consent of our board of directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of15% or more of our outstanding common stock. In addition, our board of directors has the right to issue preferred stock without stockholder approval, whichcould be used to dilute the stock ownership of a potential hostile acquirer. Although we believe these provisions of our certificate of incorporation andbylaws and Delaware law and our stockholder rights plan, which is described below, will provide for an opportunity to receive a higher bid by requiringpotential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some of our stockholders. Our board of directors adopted a stockholder rights plan, pursuant to which we declared and paid a dividend of one right for each share of commonstock held by stockholders of record as of May 14, 2001. Under the plan, each right will entitle stockholders to purchase a fractional share of our preferredstock for $150.00. Each such fractional share of the new preferred stock has terms designed to make it substantially the economic equivalent of one share ofcommon stock. Initially the rights will not be exercisable and will trade with our common stock. Generally, the rights may become exercisable if a person orgroup acquires beneficial ownership of 15% or more of our common stock or commences a tender or exchange offer upon consummation of which suchperson or group would beneficially own 15% or more of our common stock. When the rights become exercisable, our board of directors has the right toauthorize the issuance of one share of our common stock in exchange for each right that is then exercisable. 53Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Sensitivity The primary objective of our investment activities is to preserve principal while at the same time maximize the income we receive from our investmentswithout significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailinginterest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at thethen-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, wemaintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, other non-government debtsecurities and money market funds. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with theprevailing interest rate. The following table presents the amounts of our cash equivalents, short-term investments, marketable securities and long-term debtthat are subject to market risk by range of expected maturity and weighted-average interest rates as of July 3, 2005 and June 27, 2004. This table does notinclude money market funds because those funds are generally not subject to market risk. Maturing in Threemonthsor less Threemonthsto one year Greaterthan oneyear Total Fair Value (In thousands)July 3, 2005: Included in cash and cash equivalents $66,512 $66,512 $66,512Weighted average interest rate 3.01% Included in short-term investments $26,789 $101,100 $127,889 $127,889Weighted average interest rate 2.35% 2.36% Included in marketable securities $185,045 $185,045 $185,045Weighted average interest rate 2.99% Long-term debt $200,000 $200,000 $194,006Weighted average interest rate 3.50% Maturing in Threemonthsor less Threemonthsto one year Greaterthan oneyear Total Fair Value (In thousands)June 27, 2004: Included in cash and cash equivalents $470 $470 $470Weighted average interest rate 0.97% Included in short-term investments $71,355 $90,723 $162,078 $162,078Weighted average interest rate 1.96% 2.71% Included in marketable securities $204,430 $204,430 $204,430Weighted average interest rate 2.32% Long-term debt $200,000 $200,000 $181,900Weighted average interest rate 3.50% Exchange Rate Sensitivity Currently, substantially all of our sales and the majority of our expenses are denominated in United States dollars and, as a result, we have experiencedno significant foreign exchange gains and losses to date. While we have conducted some sales transactions and incurred certain operating expenses in foreigncurrencies during the year ended July 3, 2005 and expect to continue to do so, we do not anticipate that foreign exchange gains or losses will be significant,in part because of our foreign exchange risk management process discussed below. 54Table of ContentsForeign Exchange Forward Contracts We enter into foreign exchange forward contracts to hedge foreign currency forecasted transactions related to certain operating expenses, denominatedin Japanese Yen, the Euro, the Swedish Krona and the British Pound. These derivatives are designated as cash flow hedges under SFAS No. 133, Accountingfor Derivative Instruments and Hedging Activities, as amended and interpreted (“SFAS 133”). At July 3, 2005, these forward foreign currency contracts had anotional principal amount of $8.2 million (fair value of $12,000). These contracts have maturities of less than 60 days. Additionally, we enter into foreign exchange forward contracts to mitigate the effect of gains and losses generated by the remeasurement of certainassets and liabilities denominated in Japanese Yen, the Euro, the Swedish Krona and the British Pound. These derivatives are not designated as hedges underSFAS 133. At July 3, 2005, we held foreign currency forward contracts with a notional principal amount of $11.3 million (fair value of $111,000). Thesecontracts have maturities of less than 45 days. Changes in the fair value of these foreign exchange forward contracts are offset largely by remeasurement ofthe underlying assets and liabilities. We do not enter into foreign exchange forward contracts for speculative or trading purposes. Foreign currency transaction gains and losses fromoperations, including the impact of hedging, were a loss of $0.6 million in fiscal 2005, a loss of $0.5 million in fiscal 2004, and a gain of $0.4 million infiscal 2003. Investments in Equity Securities We have historically made investments in several privately held companies. These nonmarketable investments are accounted for under the costmethod, as ownership is less than 20 percent and we do not have the ability to exercise significant influence over the operating, financing and investingactivities of the investee companies. These investments are inherently risky as the market for the technologies or products they have under development aretypically in the early stages and may never materialize. It is possible that we could lose our entire initial investment in these companies. As a part ofmanagement’s process of regularly reviewing these investments for impairment, we recorded a write-down of $0.2 million for an investment which wasdetermined to be other than temporarily impaired in fiscal 2003. At July 3, 2005 and June 27, 2004, the carrying value of our remaining investments waszero. 55Table of Contents Item 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF EXTREME NETWORKS, INC. Page(s)Report of Independent Registered Public Accounting Firm 57Consolidated Balance Sheets 58Consolidated Statements of Operations 59Consolidated Statements of Stockholders’ Equity 60Consolidated Statements of Cash Flows 61Notes to Consolidated Financial Statements 62 56Table of ContentsReport of Independent Registered Public Accounting Firm The Board of Directors and StockholdersExtreme Networks, Inc. We have audited the accompanying consolidated balance sheets of Extreme Networks, Inc. as of July 3, 2005 and June 27, 2004, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended July 3, 2005. Our audits alsoincluded the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ExtremeNetworks, Inc. at July 3, 2005 and June 27, 2004, and the consolidated results of its operations and its cash flows for each of the three years in the periodended July 3, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We have also audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the effectiveness of ExtremeNetworks, Inc.’s internal control over financial reporting as of July 3, 2005, based on the criteria established in Internal Control – Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 6, 2005 expressed an unqualifiedopinion thereon. /s/ Ernst & Young LLP Palo Alto, CaliforniaSeptember 6, 2005 57Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED BALANCE SHEETS(In thousands, except par value and share amounts) July 3,2005 June 27,2004 ASSETS Current assets: Cash and cash equivalents $127,470 $59,164 Short-term investments 127,889 162,078 Accounts receivable, net of allowances of $3,572 at July 3, 2005 ($3,604 at June 27, 2004) 30,778 32,998 Inventories, net 25,943 25,889 Deferred income taxes 430 886 Prepaid expenses and other current assets, net 11,980 7,165 Total current assets 324,490 288,180 Property and equipment, net 50,438 59,767 Marketable securities 185,045 204,430 Other assets, net 23,641 26,896 Total assets $583,614 $579,273 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable $18,283 $18,995 Accrued compensation and benefits 14,032 15,827 Restructuring liabilities 6,066 6,085 Lease liability 471 2,355 Accrued warranty 7,471 8,297 Deferred revenue 36,688 33,927 Other accrued liabilities 21,893 22,921 Total current liabilities 104,904 108,407 Restructuring liabilities, less current portion 13,890 20,478 Deferred revenue, less current portion 13,785 19,747 Deferred income taxes 757 762 Other long-term liabilities 2,266 321 Convertible subordinated notes 200,000 200,000 Commitments and contingencies (Note 4) Stockholders’ equity: Convertible preferred stock, $.001 par value, issuable in series; 2,000,000 shares authorized; none issued — — Common stock, $.001 par value; 750,000,000 shares authorized; 121,908,000 issued and outstanding at July 3,2005 (120,423,000 at June 27, 2004) and capital in excess of par value 693,158 687,216 Deferred stock compensation — (69)Accumulated other comprehensive loss (2,887) (2,388)Accumulated deficit (442,259) (455,201) Total stockholders’ equity 248,012 229,558 Total liabilities and stockholders’ equity $583,614 $579,273 See accompanying notes to consolidated financial statements. 58Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts) Year Ended July 3,2005 June 27,2004 June 29,2003 Net revenues: Product $324,256 $303,293 $324,727 Service 59,091 48,555 38,549 Total net revenues 383,347 351,848 363,276 Cost of revenues: Product 146,476 137,106 172,069 Service 34,219 35,546 40,852 Total cost of revenues 180,695 172,652 212,921 Gross margin: Product 177,780 166,187 152,658 Service 24,872 13,009 (2,303) Total gross margin 202,652 179,196 150,355 Operating expenses: Sales and marketing 96,804 93,220 102,472 Research and development 61,268 58,105 58,004 General and administrative 31,754 29,604 25,733 Technology agreement 2,000 — — Impairment of acquired intangible assets — — 1,021 Amortization of deferred stock compensation 69 1,061 723 Restructuring charge — 6,487 15,939 Property and equipment write-off — — 12,678 Total operating expenses 191,895 188,477 216,570 Operating income (loss) 10,757 (9,281) (66,215)Interest income 10,713 8,584 11,069 Interest expense (7,037) (6,982) (7,058)Other income (expense), net 2,052 9,107 (190) Income (loss) before income taxes 16,485 1,428 (62,394)Provision for income taxes 3,543 3,176 134,786 Net income (loss) $12,942 $(1,748) $(197,180) Net income (loss) per share — basic $0.11 $(0.01) $(1.71)Net income (loss) per share — diluted $0.10 $(0.01) $(1.71)Shares used in per share calculation — basic 121,225 118,348 115,186 Shares used in per share calculation — diluted 124,219 118,348 115,186 See accompanying notes to consolidated financial statements. 59Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(in thousands) Common Stock andcapital in excess ofpar value DeferredStockCompensation AccumulatedOtherComprehensiveIncome (Loss) AccumulatedDeficit TotalStockholders’Equity Shares Amount Balances at June 30, 2002 115,030 $653,547 $(10,167) $1,851 $(256,273) $388,958 Components of comprehensive loss: Net loss — — — — (197,180) (197,180)Change in unrealized gain on investments, net of taxexpense of $1,407 — — — 448 — 448 Change in unrealized gain on derivatives — — — 114 — 114 Foreign currency translation adjustment — — — (107) — (107) Total comprehensive loss (196,725) Exercise of options to purchase common stock, net ofrepurchases 230 783 — — — 783 Issuance of common stock under employee stock purchase plan 1,308 5,497 — — — 5,497 Forfeiture of stock options — (7,736) 7,736 — — — Amortization of deferred stock compensation — — 723 — — 723 Balances at June 29, 2003 116,568 652,091 (1,708) 2,306 (453,453) 199,236 Components of comprehensive loss: Net loss — — — — (1,748) (1,748)Change in unrealized loss on investments, net of taxexpense of $998 — — — (5,160) — (5,160)Change in unrealized gain on derivatives — — — (1) — (1)Foreign currency translation adjustment — — — 467 — 467 Total comprehensive loss (6,442) Exercise of options to purchase common stock, net ofrepurchases 1,455 7,452 — — — 7,452 Issuance of common stock under employee stock purchase plan 1,541 5,543 — — — 5,543 Issuance of warrant to Avaya — 22,699 — — — 22,699 Exercise of warrant by Avaya 859 9 — — — 9 Forfeiture of stock options — (578) 578 — — — Amortization of deferred stock compensation — — 1,061 — — 1,061 Balances at June 27, 2004 120,423 687,216 (69) (2,388) (455,201) 229,558 Components of comprehensive income: Net income — — — — 12,942 12,942 Change in unrealized loss on investments, net of taxexpense of $156 — — — (540) — (540)Change in unrealized gain on derivatives — — — 12 — 12 Foreign currency translation adjustment — — — 29 — 29 Total comprehensive income 12,443 Exercise of options to purchase common stock, net ofrepurchases 542 1,799 — — — 1,799 Issuance of common stock under employee stock purchase plan 943 4,143 — — — 4,143 Amortization of deferred stock compensation — — 69 — — 69 Balances at July 3, 2005 121,908 $693,158 $— $(2,887) $(442,259) $248,012 See accompanying notes to consolidated financial statements. 60Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands) Year Ended July 3,2005 June 27,2004 June 29,2003 Cash flows from operating activities: Net income (loss) $12,942 $(1,748) $(197,180)Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 16,244 20,141 25,929 Impairment of acquired intangible assets — — 1,021 Provision for doubtful accounts 380 (200) — Provision for excess and obsolete inventory 1,061 1,252 300 Deferred income taxes 451 (188) 133,563 Amortization of warrant 7,566 5,044 — Restructuring charge — 6,487 15,939 Property and equipment write-off — — 12,678 Amortization of deferred stock compensation 69 1,061 723 Equity share of affiliate losses and write-down of investments — — 250 Loss on disposal of assets 212 — — Changes in operating assets and liabilities, net Accounts receivable 2,271 (6,004) 24,550 Inventories (1,114) (8,431) 5,617 Prepaid expenses and other assets (9,558) 11,814 (2,818)Accounts payable (712) (25) (10,195)Accrued compensation and benefits (1,795) 1,162 (135)Restructuring liabilities (6,607) (7,972) (6,579)Lease liability (1,884) (2,041) (3,667)Accrued warranty (825) (1,903) 1,145 Deferred revenue (3,201) 5,376 7,526 Other accrued liabilities (987) (2,396) 1,404 Other long-term liabilities 1,945 39 10 Net cash provided by operating activities 16,458 21,468 10,081 Cash flows from investing activities: Capital expenditures (7,127) (6,263) (14,716)Purchases of investments (297,051) (306,365) (582,910)Proceeds from sales and maturities of investments 350,084 292,980 553,775 Net cash provided by (used) in investing activities 45,906 (19,648) (43,851) Cash flows from financing activities: Proceeds from issuance of common stock, net of repurchases 5,942 13,004 6,280 Net cash provided by financing activities 5,942 13,004 6,280 Net increase (decrease) in cash and cash equivalents 68,306 14,824 (27,490)Cash and cash equivalents at beginning of year 59,164 44,340 71,830 Cash and cash equivalents at end of year $127,470 $59,164 $44,340 Supplemental disclosure of cash flow information: Interest paid $7,037 $7,060 $7,058 Cash paid for income taxes $1,819 $2,612 $3,696 See accompanying notes to consolidated financial statements. 61Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Description of Business Extreme Networks, Inc. (“Extreme Networks” or the “Company”) is a leading provider of network infrastructure equipment and markets its productsprimarily to business, governmental, health care and educational customers with a focus on large corporate enterprises and metropolitan service providers ona global basis. We conduct our sales and marketing activities on a worldwide basis through a two-tier distribution channel utilizing distributors, resellers andour field sales organization. Extreme Networks was incorporated in California in 1996 and reincorporated in Delaware in 1999. 2. Basis of Presentation and Summary of Significant Accounting Policies Fiscal Year Our fiscal year is a 52/53-week fiscal accounting year that closes on the Sunday closest to June 30th every year. Fiscal 2005 was a 53-week fiscal year;fiscal 2004 and fiscal 2003 were 52-week fiscal years. All references herein to “fiscal 2005” or “2005” represent the fiscal year ended July 3, 2005. Principles of Consolidation The consolidated financial statements include the accounts of Extreme Networks and its wholly-owned subsidiaries. All inter-company accounts andtransactions have been eliminated. Investments in which management intends to maintain more than a temporary 20% to 50% interest, or otherwise has theability to exercise significant influence, are accounted for under the equity method. Investments in which management has less than a 20% interest and doesnot have the ability to exercise significant influence are carried at the lower of cost or estimated realizable value. We use the U.S. dollar predominately as our functional currency. The functional currency for certain of our foreign subsidiaries is the local currencybased on the criteria of SFAS No. 52, Foreign Currency Translation. For those subsidiaries that operate in a local currency functional environment, allmonetary assets and liabilities are translated to United States dollars at current rates of exchange; non-monetary assets and liabilities are translated athistorical rates of exchange; and revenues and expenses are translated using average rates. Gains and losses from foreign currency translation are included asa separate component of other comprehensive income (loss). Foreign currency transaction losses from operations, including the impact of hedging, were $0.6million in fiscal 2005 and $0.5 million in fiscal 2004. Foreign currency transaction gains from operations, including the impact of hedging, were $0.4 millionin fiscal 2003. Accounting Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates areused for, but are not limited to, the accounting for the allowances for doubtful accounts and returns, inventory valuation, depreciation and amortization,impairment of long-lived assets, warranty accruals, restructuring liabilities and income taxes. Actual results could differ materially from these estimates. Reclassifications We have reclassified $19.7 million of deferred revenue from current to long-term as of June 27, 2004 in order to conform to the fiscal 2005presentation. This reclassification has not impacted previously reported revenues, operating loss, net loss or net cash provided by operating activities. 62Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Revenue Recognition We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated fromservice fees relating to the service contracts and training on our products. We generally recognize product revenue from our value-added resellers and end-users at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed ordeterminable and collection of the sales proceeds is reasonably assured. Revenue from service obligations under service contracts is deferred and recognizedon a straight-line basis over the contractual service period. Service contracts typically range from one to five years. When sales arrangements contain multipledeliverables, such as hardware, service contracts and other services, we determine whether the deliverables represent separate units of accounting and thenallocate revenue to each unit of accounting based on their relative fair values. We recognize revenue for each unit of accounting when the revenuerecognition criteria for each unit of accounting are met. Shipping costs are included in cost of product revenues. We make certain sales to partners in two distribution channels, or tiers. The first tier consists of a limited number of independent distributors that sellprimarily to resellers and, on occasion, to end-user customers. We defer recognition of revenue on all sales to these distributors until the distributors sell theproduct, as evidenced by monthly “sales-out” reports that the distributors provide to us. We grant these distributors the right to return a portion of unsoldinventory to us for the purpose of stock rotation. We also grant these distributors certain price protection rights. The distributor-related deferred revenue andreceivables are adjusted at the time of the stock rotation return or price reduction. We also provide distributors with credits for changes in selling prices, andallow them to participate in cooperative marketing programs. Cooperative advertising expenses are recorded as marketing expenses to the extent that anadvertising benefit separate from the revenue transaction can be identified and the cash paid does not exceed the fair value of that advertising benefitreceived. We maintain estimated accruals and allowances for these exposures based upon our historical experience. The second tier of the distributionchannel consists of a large number of third-party resellers that sell directly to end-users and are not granted return privileges, except for defective productsduring the warranty period. We reduce product revenue for certain price protection rights that may occur under contractual arrangements we have with ourresellers. Cash Equivalents, Short-Term Investments and Marketable Securities Highly liquid investment securities with insignificant interest rate risk and with original maturities of three months or less at date of purchase areclassified as cash equivalents. Investment securities with original maturities greater than three months and remaining maturities of less than one year areclassified as short-term investments. Investment securities with remaining maturities greater than one year are classified as marketable securities. Ourinvestments are primarily comprised of United States and municipal government obligations and corporate securities. To date, all marketable securities have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses reported net-of-tax as a separate component of stockholders’ equity. Realized gains and losses on available-for-sale securities are recorded in interest income. Declines invalue on available-for-sale securities judged to be other than temporary are recorded in other income (expense), net. None of our marketable securities aredeemed impaired as of July 3, 2005, as substantially all of our investments are investment grade government and corporate debt securities that havematurities of less than 3 years, and we have both the ability and intent to hold the investments until maturity. The cost of securities sold is based on specificidentification. Premiums and discounts are amortized over the period from acquisition to maturity and are included in investment income, along with interestand dividends. We have made minority investments in privately held companies. Our interest in these companies was significantly less than 20% and, as such, we didnot have the ability to exercise significant influence. We monitor 63Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) our minority investments for other than temporary impairment and make appropriate reductions in carrying values when necessary. We recorded write-downsof $0.2 million during fiscal 2003 related to impairments of our privately held investments. The carrying value of investments in privately held companieswas zero as of July 3, 2005 and June 27, 2004. Fair Value of Financial Instruments The carrying amounts and estimated fair values of our financial instruments were as follows (in thousands): July 3, 2005 June 27, 2004 Carrying amount Fair value Carrying amount Fair value Financial assets: Cash and cash equivalents $127,470 $127,470 $59,164 $59,164 Short-term investments $127,889 $127,889 $162,078 $162,078 Marketable securities $185,045 $185,045 $204,430 $204,430 Financial liabilities: Convertible subordinated notes $200,000 $194,006 $200,000 $181,900 Forward foreign currency contracts $(99) $(99) $(115) $(115) The fair values of short-term investments and marketable securities are determined using quoted market prices for those securities or similar financialinstruments. The fair value of the convertible subordinated notes due December 1, 2006 is estimated using quoted market prices. Concentrations We may be subject to concentration of credit risk as a result of certain financial instruments consisting principally of marketable investments andaccounts receivable. We have placed our investments with high-credit quality issuers. We will not invest an amount exceeding 10% of our combined cash,cash equivalents, short-term investments and marketable securities in the securities of any one obligor or maker, except for obligations of the United Statesgovernment, obligations of United States government agencies and money market accounts. We perform ongoing credit evaluations of our customers and generally do not require collateral in exchange for credit. We mitigate some collectionrisk by requiring most of our customers in the Asia-Pacific region, excluding Japan, to pay cash in advance or secure letters of credit when placing an orderwith us. One distributor of our products, Tech Data Corporation, accounted for 11% of our net revenues in both fiscal 2005 and 2003. No distributor orcustomer accounted for more than 10% of our net revenues in fiscal 2004. No customer accounted for more than 10% of our accounts receivable balance atJuly 3, 2005 or June 27, 2004. One supplier currently manufacturers all of our application specific integrated circuits, or ASICs, used in all of our hardware products. Any interruptionor delay in the supply of any of these or other single source components, or the inability to procure these components from alternate sources at acceptableprices and within a reasonable timeframe, would have a material adverse effect on our ability to meet customer orders, which would negatively impact ourbusiness, operating results and financial condition. In addition, qualifying additional suppliers can be time-consuming and expensive, and may increase thelikelihood of design or production related errors. We attempt to mitigate these risks by working closely with our ASIC supplier regarding productionplanning and timing of new product introductions. 64Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) We currently derive substantially all of our revenue from sales of our Summit, BlackDiamond and Alpine products. We expect that revenue from theseproducts will account for a substantial portion of our revenue for the foreseeable future. Accordingly, widespread market acceptance of these products iscritical to our future success. Allowance for Doubtful Accounts We continually monitor and evaluate the collectibility of our trade receivables based on a combination of factors. We record specific allowances forbad debts in general and administrative expense when we become aware of a specific customer’s inability to meet its financial obligation to us, such as in thecase of bankruptcy filings or deterioration of financial position. We write off receivables to the allowance after all collection efforts are exhausted. Estimatesare used in determining our allowances for all other customers based on factors such as current trends in the length of time the receivables are past due andhistorical collection experience. We mitigate some collection risk by requiring most of our customers in the Asia-Pacific region, excluding Japan, to pay cashin advance or secure letters of credit when placing an order with us. Inventories Inventories consist of raw materials and finished goods and are stated at the lower of cost, determined on a first-in, first-out basis, or market. Inventories,net of allowances for excess and obsolete inventory (which we determine primarily based on future demand forecasts) of $4,790 and $6,365 at July 3, 2005and June 27, 2004, respectively, consist of (in thousands): July 3, 2005 June 27, 2004Raw materials $369 $695Finished goods 25,574 25,194 Total $25,943 $25,889 Sales to Distributors We defer recognition of revenue on all sales to distributors until the distributor successfully resells the product, typically to an authorized reseller.Distributors regularly provide us their “sales-out” reports for this purpose. Until it is sold, inventory held by distributors is included in our reported finishedgoods inventory and was $3.7 million and $5.1 million at July 3, 2005 and June 27, 2004, respectively. The accounts receivable owed us by distributors, netof the deferred revenue from sales to distributors, is recorded in prepaid expenses and other current assets, as reflected in the following table (in thousands): July 3, 2005 June 27, 2004 Accounts receivable, net of allowance for doubtful accounts of $619 ($724 in fiscal2004) $23,249 $20,350 Deferred revenue (16,779) (20,151) Net, included in Prepaid expenses and other current assets $6,470 $199 65Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Property and Equipment, Net Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using thestraight-line method over the estimated useful lives of the assets, with the exception of land, which is not depreciated. Estimated useful lives of 25 years areused for buildings. Estimated useful lives of one to four years are used for computer equipment and software. Estimated useful lives of three years are used foroffice equipment, furniture and fixtures. Depreciation and amortization of leasehold improvements is computed using the lesser of the remaining lease termsor three years. Property and equipment consist of the following (in thousands): July 3, 2005 June 27, 2004 Computer equipment $55,260 $50,454 Land 20,600 20,600 Buildings and improvements 17,493 17,400 Purchased software 31,122 29,795 Office equipment, furniture and fixtures 4,178 4,115 Leasehold improvements 6,175 6,109 134,828 128,473 Less accumulated depreciation and amortization (84,390) (68,706) Property and equipment, net $50,438 $59,767 Goodwill and Other Long-Lived Assets Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), requires goodwill to be tested forimpairment on an annual basis and between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previousstandards required. Furthermore, SFAS 142 requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these livesare determined to be indefinite. We adopted this statement on July 1, 2002. In accordance with SFAS 142, we ceased amortizing goodwill as of July 1, 2002.In accordance with SFAS 142, we performed the annual impairment review of our goodwill at the end of fiscal 2003. During this evaluation, we notedindicators that the carrying value of our goodwill might not be recoverable due to the prolonged economic downturn affecting our operations and revenueforecasts, and recorded an impairment charge for the remaining $1.0 million of goodwill. At July 3, 2005 and June 27, 2004, there was no remaining goodwillin our consolidated balance sheets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may notbe recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventualdisposition. Measurement of an impairment loss for long-lived assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Other assets include technology agreements that are amortized over their contractual periods using the straight-line method of amortization. Therelated liability for the technology agreement is recorded in other accrued liabilities and other long-term liabilities. Guarantees and Product Warranties Financial Accounting Standards Board (“FASB”) Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others (“FIN 45”) requires that upon issuance of a guarantee, the guarantor must disclose and recognize aliability for the fair value of the obligation it assumes under that guarantee. 66Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) We have determined that the requirements of FIN 45 apply to our standard product warranty liability. The following table summarizes the activityrelated to our product warranty liability during fiscal 2005, fiscal 2004, and fiscal 2003: Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Balance beginning of period $8,297 $10,200 $9,055 New warranties issued 12,251 11,791 15,496 Warranty expenditures (14,205) (13,694) (14,351)Change in estimate 1,128 — — Balance end of period $7,471 $8,297 $10,200 Our standard hardware warranty period is typically 12 months from the date of shipment to end-users. Upon shipment of products to our customers, weestimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability in cost of product revenue for thisamount. The determination of our warranty requirements is based on actual historical experience with the product or product family, estimates of repair andreplacement costs and any product warranty problems that are identified after shipment. We estimate and adjust these accruals at each balance sheet date inaccordance with changes in these factors. The change in estimate in fiscal 2005 results from a change in the method we use to accumulate warranty returnrates. There have been no changes in these estimates for fiscal 2004 and fiscal 2003. In the normal course of business to facilitate sales of our products, we indemnify our resellers and end-user customers with respect to certain matters.We have agreed to hold the customer harmless against losses arising from a breach of intellectual property infringement or other claims made against certainparties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. It is not possible to estimatethe maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts andcircumstances involved in each particular agreement. Historically, payments made by us under these agreements have not had a material impact on ouroperating results or financial position. The requirements of FIN 45 are applicable to a guarantee of a lease obligation of one of our former contract manufacturers and to letters of credit issuedunder our line of credit. As of July 3, 2005, the lease obligation in the amount of $0.5 million has been recognized as a lease liability on the consolidatedbalance sheet and letters of credit totaled $0.8 million. Deferred Support Revenue We offer renewable support arrangements, including extended warranty contracts, to our customers that range generally from one to five years. Thechange in our deferred support revenue balance in relation to these arrangements was as follows (in thousands): Year Ended July 3, 2005 June 27, 2004 Balance beginning of period $50,178 $44,220 New support arrangements 51,392 49,918 Recognition of support revenue (53,721) (43,960) Balance end of period 47,849 50,178 Less current portion 34,064 30,431 Non-current deferred revenue $13,785 $19,747 67Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Other Accrued Liabilities The following are the components of other accrued liabilities (in thousands): July 3, 2005 June 27, 2004Accrued income taxes $2,034 $1,672Accrued indirect taxes 2,344 3,386Accrued interest on subordinated debt 583 583Other accrued liabilities 16,932 17,280 Total $21,893 $22,921 Stock-Based Compensation As provided by Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock Based Compensation (“SFAS 123”), we haveelected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), in accounting for our employee stock options. Under APBNo. 25, when the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant, no compensation expenseis recognized in our financial statements. Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS 123. This information is required to be determinedas if we had accounted for our employee stock options and shares issued under the Employee Stock Purchase Plan under the fair value method of thatstatement. The fair value of options granted in fiscal 2005, fiscal 2004, and fiscal 2003 was estimated at the date of grant using a Black-Scholes optionpricing model with the following weighted average assumptions: Stock Option Plan Employee Stock Purchase Plan Year Ended Year Ended July 3,2005 June 27,2004 June 29,2003 July 3,2005 June 27,2004 June 29,2003 Expected life 2.5 yrs 3.0 yrs 3.4 yrs 0.8 yrs 0.6 yrs 0.6 yrs Risk-free interest rate 2.9% 2.3% 2.3% 2.9% 1.3% 1.1%Volatility 81% 77% 97% 47% 58% 86%Dividend yield 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected life of the stock-based awardand stock price volatility. The assumptions listed above represent management’s best estimates, but these estimates involve inherent uncertainties. As aresult, if other assumptions had been used, our pro forma stock-based compensation expense could have been materially different from that depicted below. The weighted-average estimated per share fair value of options granted in fiscal 2005, fiscal 2004, and fiscal 2003 was $2.51, $3.56, and $3.41,respectively. The weighted-average estimated per share fair value of shares granted under the Employee Stock Purchase Plan in fiscal 2005, fiscal 2004, andfiscal 2003 was $1.49, $2.17, and $1.92, respectively. Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS123. This information is required to be determined as if we had accounted for employee stock options and shares issued under the Employee Stock PurchasePlan under the fair value method of that statement. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense overthe 68Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) options’ vesting periods using the graded vested method. The following pro forma information sets forth our net loss and net loss per share assuming that wehad used the SFAS 123 fair value method in accounting for employee stock options and purchases (in thousands, except per share amounts): Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Net income (loss) — as reported $12,942 $(1,748) $(197,180)Add: APB 25 stock-based compensation expense, as reported 339 1,061 470 Less: Stock-based employee compensation expense determined under fair valuebased method, net of tax (32,496) (29,197) (24,347) Pro forma net loss $(19,215) $(29,884) $(221,057) Basic net income (loss) per share: As reported $0.11 $(0.01) $(1.71)Pro forma $(0.16) $(0.25) $(1.92)Diluted net income (loss) per share: As reported $0.10 $(0.01) $(1.71)Pro forma $(0.15) $(0.25) $(1.92) On June 24, 2005, the Compensation Committee of the Company’s Board of Directors approved the acceleration of vesting of certain unvested stockoptions with exercise prices equal to or greater than $7.00 per share previously awarded to employees, including executive officers, and directors. Options topurchase approximately 4,544,000 shares of common stock were subject to acceleration. The stock-based employee compensation expense of approximately$11.4 million related to the accelerated vesting of these options is included in the pro forma information for the period ended July 3, 2005, and will not berecognized in our earnings after SFAS 123 (R) is adopted. In accordance with APB No. 25, as the exercise price of the employee stock options was higher thanthe market price of our stock on the date of the modification of the options, no compensation expense was recognized in our consolidated statement ofoperations. Stock compensation expense for options granted to nonemployees has been determined in accordance with SFAS 123 and EITF 96-18, Accounting forEquity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with, Selling Goods or Services, as the fair value of theconsideration received or the fair value of the equity instruments issued, whichever is more reliably measured. The fair value of options granted tononemployees is remeasured as the underlying options vest. There were no options granted to non-employees in fiscal 2005. Derivatives We use derivative financial instruments to manage exposures to foreign currency. Our objective for holding derivatives is to use the most effectivemethods to minimize the impact of these exposures. We do not enter into derivatives for speculative or trading purposes. All derivatives, whether designatedin hedging relationships or not, are required to be recorded on the balance sheet at fair value. The accounting for changes in the fair value of a derivativedepends on the intended use of the derivative and the resulting designation. For a derivative designated as a cash flow hedge, the effective portion of thederivative’s gain or loss is initially reported as a component of accumulated other comprehensive income (loss) and, upon occurrence of the forecastedtransaction, is subsequently reclassified into the consolidated statement of operations line item to which the hedged transaction relates. The ineffectiveportion of the gain or loss is reported in other expense immediately. For a derivative not designated as a cash flow hedge, the gain or loss is recognized inother expense in the period of change together with the offsetting gain or loss on the hedged item attributed to the risk being hedged. 69Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Advertising Cooperative advertising obligations with customers are accrued and the costs expensed at the time the related revenue is recognized. All otheradvertising costs are expensed as incurred. Cooperative advertising expenses are recorded as marketing expenses to the extent that an advertising benefitseparate from the revenue transaction can be identified and the cash paid does not exceed the fair value of that advertising benefit received. Otherwise, suchcooperative advertising obligations with customers are recorded as a reduction of revenue. Advertising expenses were $0.5 million, $1.4 million, and $3.8million for fiscal 2005, fiscal 2004, and fiscal 2003, respectively. Recently Issued Accounting Standards Share-Based Payment On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS123(R)”), which is a revision of SFAS 123. SFAS 123(R) supersedes APB 25 and amends SFAS 95, Statement of Cash Flows. Generally, the approach in SFAS123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure is no longer an alternative. We expectto adopt SFAS 123(R) at the beginning of our first quarter of fiscal 2006. SFAS 123(R) permits public companies to adopt its requirements using one of two methods: 1) a “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted afterthe effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remainunvested on the effective date: or 2) a “modified retrospective” method, which includes the requirements of the modified prospective method describedabove, but also permits entities to restate based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year of adoption. We plan to adopt SFAS 123(R) using the modified-prospective method. We are currently evaluating the requirements of SFAS 123(R) and we have not yet fully determined the impact on our consolidated financialstatements. We believe the impact to our financial statements will result in a material increase in our stock-based employee compensation expenserecognized in our consolidated statements of operations, although it will have no impact on our overall financial position. The stock-based employeecompensation expense presented in our pro forma financial results required to be disclosed under SFAS 123 was $32.2 million, $29.2 million and $24.3million in fiscal 2005, fiscal 2004, and fiscal 2003, respectively. Additionally, SFAS 123(R) also requires the benefits of tax deductions in excess ofrecognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. Thisrequirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. In March 2005, SEC staff issued Staff Accounting Bulletin (“SAB”) No. 107, Share-Based Payment, which provides guidance on the interactionbetween SFAS No. 123(R) and certain SEC rules and regulations, as well as on the valuation of share-based payments. SAB No. 107 does not modify any ofthe requirements under SFAS No. 123(R). SAB No. 107 provides interpretive guidance related to valuation methods (including assumptions such as expectedvolatility and expected term), first time adoption of SFAS 123(R) in an interim period, the classification of compensation expense and disclosures subsequentto adoption of SFAS No. 123(R). We are currently evaluating the impact of SAB No. 107 on our consolidated financial statements. 70Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Inventory Costs In November 2004, the FASB issued SFAS 151, Inventory Costs – an amendment of ARB No. 43, Chapter 4, which requires companies to expenseabnormal freight, handling costs, or spoilage in the period incurred and to allocate fixed overhead based on normal capacity, with adjustment if production isabnormally high. This standard becomes effective for the Company on July 1, 2005. We currently account for abnormal freight, handling costs, and spoilageconsistent with this standard. We plan to adopt the provisions on a prospective basis in the first fiscal quarter of 2006. We are currently evaluating the effectsof implementing this standard, however, we do not expect it to have a material impact on our financial position and results of operations. Identification of Impaired Investments In March 2004, the FASB approved the consensus reached on EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments (“EITF 03-1”). EITF 03-1 provides new guidance for evaluating impairment losses on debt and equity investments, aswell as new disclosure requirements for investments that are determined to be other-than-temporarily impaired. In September 2004, the FASB approved theissuance of a FASB Staff Position to delay the requirement to record impairment losses under EITF 03-1. In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment under EITF 03-1. The FASBdirected the staff to issue FASB Staff Position Paper (“FSP”) 115-1, The Meaning of Other-Than-Temporary Impairment and its Application to CertainInvestments (“FSP 115-1”), superseding EITF 03-1. FSP 115-1 will replace the accounting guidance on the determination of whether an investment is other-than-temporarily impaired as set forth in EITF 03-1 with references to existing other-than-temporary impairment guidance. FSP 115-1 will be effective forother-than-temporary impairment analyses conducted in periods beginning after September 15, 2005. As substantially all of our investments are investment grade government and corporate debt securities that have maturities of less than 3 years, and wehave both the ability and intent to hold the investments until maturity, we do not expect FSP 115-1 to have a material impact on our financial position andresults of operations. Accounting for Income Taxes In December 2004, the FASB issued FSP No. FAS 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deductionon Qualified Production Activities Provided by the American Jobs Creation Act of 2004. On October 22, 2004, the American Jobs Creation Act of 2004 (the“AJCA”) was signed into law. The AJCA provides a new deduction for certain qualified domestic production activities. FSP No. 109-1 is effectiveimmediately and clarifies that such deduction should be accounted for as a special deduction, not as a tax rate reduction, under SFAS No. 109, Accountingfor Income Taxes, no earlier than the year in which the deduction is reported on the tax return. We are currently evaluating whether such deduction may beavailable to us and its impact on our consolidated financial statements. We will recognize the tax benefit of such deductions, if any, beginning in fiscal 2006. In December 2004, the FASB issued FSP No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisionwithin the American Jobs Creation Act of 2004. The AJCA provides a one-time 85% dividends received deduction for certain foreign earnings that arerepatriated under a plan for reinvestment in the United States, provided certain criteria are met. FSP No. 109-2 is effective immediately and providesaccounting and disclosure guidance for the repatriation provision. FSP No. 109-2 allows companies additional time to evaluate the effects of the law on itsunremitted earnings for the purpose of applying the 71Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) “indefinite reversal criteria” under APB Opinion 23, Accounting for Income Taxes – Special Areas, and requires explanatory disclosures from companies thathave not yet completed the evaluation. The Company is currently evaluating the effects of the repatriation provision and their impact on our consolidatedfinancial statements; however, we do not believe that we will benefit from this provision of the AJCA. 3. Available-for-Sale Securities The following is a summary of available-for-sale securities (in thousands): AmortizedCost Fair Value UnrealizedHoldingGains UnrealizedHoldingLosses July 3, 2005: Money market funds $66,512 $66,512 $— $— U.S. corporate debt securities 193,934 191,842 5 (2,097)U.S. government agency securities 117,685 116,552 7 (1,140)U.S. municipal bonds 4,610 4,540 — (70) $382,741 $379,446 $12 $(3,307) Classified as: Cash equivalents $66,512 $66,512 $— $— Short-term investments 128,927 127,889 1 (1,039)Marketable securities 187,302 185,045 11 (2,268) $382,741 $379,446 $12 $(3,307) June 27, 2004: Money market funds $470 $470 $— $— Foreign debt securities 9,124 9,129 45 (40)U.S. corporate debt securities 222,416 221,420 507 (1,503)U.S. government agency securities 74,715 73,824 14 (905)U.S. municipal bonds 40,371 40,339 33 (65)Market auction preferred securities 21,796 21,796 — — $368,892 $366,978 $599 $(2,513) Classified as: Cash equivalents $470 $470 $— $— Short-term investments 161,654 162,078 525 (101)Marketable securities 206,768 204,430 74 (2,412) $368,892 $366,978 $599 $(2,513) The amortized cost and estimated fair value of available-for-sale investments in debt securities at July 3, 2005, by contractual maturity, were as follows(in thousands): AmortizedCost FairValueDue in 1 year or less $195,439 $194,401Due in 1-2 years 147,222 145,143Due in 2-5 years 40,080 39,902 Total investments in available for sale debt securities $382,741 $379,446 72Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) The following table presents our investments’ gross unrealized losses and fair values, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position. Less than 12 months 12 months or more Total Fair Value UnrealizedLosses Fair Value UnrealizedLosses Fair Value UnrealizedLosses July 3, 2005: U.S. corporate debt securities $77,386 $(706) $102,800 $(1,391) $180,186 $(2,097)U.S. government agency securities 54,938 (321) 58,084 (819) 113,022 (1,140)U.S. municipal bonds 919 (21) 3,621 (49) 4,540 (70) $133,243 $(1,048) $164,505 $(2,259) $297,748 $(3,307) Municipal and corporate bonds. Unrealized losses as of July 3, 2005 on our investments in municipal and corporate bonds were caused by interest rateincreases. The contractual terms of the debentures do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Theissuers of our municipal bonds have a credit rating of AAA, and the issuers of our corporate bonds have a credit rating of AA (Moody’s and S&P). Government agency securities. Unrealized losses as of July 3, 2005 on our investments in our government agency securities (i.e., Federal NationalMortgage Association and Federal Home Loan Mortgage Corp.) were caused by interest rate increases. The contractual terms of the investments do not permitthe issuer to settle the securities at a price less than the amortized cost of the investment. The issuers of our government agency securities have a credit ratingof AAA. The unrealized losses on our investments were caused by interest rate increases. As substantially all of our investments are investment gradegovernment and corporate debt securities that have maturities of less than 3 years, and we have both the ability and intent to hold the investments untilmaturity, we do not consider these investments to be other-than-temporarily impaired at July 3, 2005. 4. Commitments, Contingencies and Leases Line of Credit We have a revolving line of credit for $10.0 million with a major lending institution. Borrowings under this line of credit bear interest at the bank’sprime rate. As of July 3, 2005, there were no outstanding borrowings under this line of credit. The line of credit contains a provision for the issuance of lettersof credit not to exceed the unused balance of the line. As of July 3, 2005, we had letters of credit totaling $0.8 million. These letters of credit were primarilyissued to satisfy requirements of certain of our customers for performance bonds. The line of credit requires us to maintain specified financial covenantsrelated to tangible net worth and liquidity with which we were in compliance as of July 3, 2005. The line of credit expires on January 26, 2006. Leases As part of our business relationship with MCMS, Inc. (“MCMS”), a former contract manufacturer, we entered into a $9.0 million operating equipmentlease for manufacturing equipment in September 2000 with a third-party financing company; we, in turn, subleased the equipment to MCMS. The equipmentlease with the third-party financing company requires us to make monthly payments through September 2005 and to maintain specified financial covenantswith which we were in compliance as of July 3, 2005. The liability, net of payments, related to this lease is included in lease liability on the consolidatedbalance sheets. 73Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) We lease office space for our various United States and international sales offices. Certain leases contain rent escalation clauses and renewal options.We sublease certain of our leased facilities to third party tenants. Future annual minimum lease payments under all noncancelable operating leases and futurerental income under all noncancelable subleases having initial or remaining lease terms in excess of one year at July 3, 2005 were as follows (in thousands): Future LeasePayments Future RentalIncomeFiscal 2006 $9,438 $474Fiscal 2007 8,290 427Fiscal 2008 4,565 73Fiscal 2009 3,838 — Fiscal 2010 3,946 — Thereafter 3,766 — Total minimum payments $33,843 $974 Rent expense was approximately $5.1 million, $5.4 million, and $6.3 million for fiscal 2005, fiscal 2004, and fiscal 2003, respectively, net of subleaseincome of $0.4 million, $0.3 million, and $0.1 million in the respective periods. Purchase Commitments We currently have arrangements with one contract manufacturer and other suppliers for the manufacture of our products. Our arrangements allow themto procure long lead-time component inventory on our behalf based upon a rolling production forecast provided by us. We are obligated to the purchase oflong lead-time component inventory that our contract manufacturer procures in accordance with the forecast, unless we give notice of order cancellationoutside of applicable component lead-times. As of July 3, 2005, we had non-cancelable commitments to purchase approximately $15.1 million of suchinventory during the first quarter of fiscal 2006. Legal Proceedings On June 21, 2005, Enterasys Networks, Inc. filed suit against Extreme Networks and Foundry Networks, Inc. (“Foundry”) in the United States DistrictCourt for the District of Delaware, Civil Action No.05-11298 DPW. The complaint alleges willful infringement of U. S. Patent Nos.5,251,205; 5,390,173;6,128,665; 6,147,995; 6,539,022; and 6,560, 236, and seeks a judgment: (a) determining that we have willfully infringed each of the patents; (b) permanentlyenjoining us from infringement, inducement of infringement and contributory infringement of each of the six patents; (c) awarding damages and a“reasonable royalty” to be determined at trial; (d) awarding trebled damages; (e) awarding attorneys fees, costs and interest; and (f) awarding equitable reliefat the court’s discretion. We intend to evaluate the assertions, answer the complaint, and vigorously to defend against Enterasys’ assertions that we believe tobe without merit. On May 27, 2003, Lucent filed suit against Extreme Networks and Foundry in the United States District Court for the District of Delaware, Civil ActionNo. 03-508. The complaint alleged willful infringement of U.S. Patent Nos. 4,769,810, 4,769,811, 4,914,650, 4,922,486 and 5,245,607. The Judge split thecase into three parts to be tried separately: phase 1 to cover infringement, willfulness and damages; phase 2 to cover invalidity; and phase 3 to coverequitable defenses and Extreme’s counterclaims. On May 9, 2005, a jury in Delaware awarded Extreme a phase 1 verdict of non-infringement on 18 out of the19 claims asserted. The jury did award Lucent damages of approximately $275,000 on the remaining claim; which covers a feature that is not offered in 74Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Extreme’s current product line. The parties each filed post-trial motions; and on August 16, 2005, the judge granted Lucent’s motion for a new trial, rulingthat Extreme impermissibly introduced to the jury evidence of its prior relationship with Lucent. The new trial on phase 1 and the remaining phases have notyet been scheduled for trial. Extreme intends vigorously to defend against Lucent’s claims and the judge’s ruling, and to try the remainder of the case. Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint was brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8,1999 through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondaryoffering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings inexchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in theaftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. Theamended complaint also alleges that false analyst reports were issued. No specific damages are claimed. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims underSection 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. We have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will notbe required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of theinsurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured. If thesettlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on ourconsolidated financial position, results of operations and cash flows in the future. We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters,including the specific matters discussed above, is currently not determinable, the ultimate costs to resolve these matters could have a material adverse effecton our consolidated financial position, results of operations or cash flows. 75Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 5. Convertible Subordinated Notes In December 2001, we completed a private placement of $200.0 million of convertible subordinated notes. The notes mature on December 1, 2006.Interest is payable semi-annually at 3.5% per annum. The notes are convertible at the option of the holders into our common stock at an initial conversionprice of $20.96 per share, subject to adjustment. In lieu of issuing common shares, the notes are redeemable in cash at the option of Extreme Networks, if notconverted to common stock prior to the redemption date, at a redemption price of: 101.4% of the principal amount between December 2004 and November2005; 100.7% of the principal amount between December 2005 and November 2006; and 100% thereafter. We have reserved 9,544,260 shares of commonstock for the conversion of these notes. Offering costs of $6.5 million are included in other assets and are amortized using the interest method. Each holder ofthe notes has the right to cause us to repurchase all of such holder’s convertible notes at 100% of the principal amount plus accrued interest upon a change ofcontrol of ownership of Extreme Networks, as defined in the notes. 6. Stockholders’ Equity Preferred Stock In April 2001, in connection with our Stockholders’ Rights Agreement, we authorized the issuance of preferred stock. The preferred stock may beissued from time to time in one or more series. The board of directors is authorized to provide for the rights, preferences and privileges of the shares of eachseries and any qualifications, limitations or restrictions on these shares. As of July 3, 2005, no shares of preferred stock were outstanding. Warrants On October 30, 2003, Extreme Networks and Avaya, Inc. entered into a strategic alliance to jointly develop and market converged communicationssolutions, by executing a Joint Development Agreement, and a distribution agreement under which Avaya is entitled to resell Extreme Networks products.Extreme issued to Avaya a warrant with a ten-year expiration period to purchase up to 2,577,794 shares of Extreme Networks common stock at a price of$0.01 per share, with Avaya having the right to exercise the warrant with respect to one third of such shares 90 days after the date of the agreements, and theremaining shares become exercisable based upon the completion of certain milestones by Avaya. Even if the milestones are not completed, however, thewarrant will become fully exercisable for all shares 90 days prior to the expiration of the warrant. Avaya exercised the warrant with respect to one third of theshares subject to the warrant on March 17, 2004 and, accordingly, approximately 859,000 shares of our common stock were issued to Avaya on that date. Deferred Stock Compensation During fiscal 2001, we recorded deferred stock-based compensation expense of $24.4 million associated with unvested stock options subject toforfeiture issued to employees assumed in acquisitions. These amounts are being amortized as charges to operations, using the graded method, over thevesting periods of the individual stock options, generally four years. Upon termination of an employee, the amount of expense recognized under the gradedvesting method that is in excess of the amount actually earned is reversed. For the year ended June 29, 2003, we reversed $5.3 million of excesscompensation expense (including $2.8 million related to forfeitures that occurred in prior years but which, due to oversight, were not accounted for until thefourth quarter of fiscal 2003) related to terminated employees. We do not believe the $2.8 million amount recorded in the fourth quarter of fiscal 2003 wasmaterial to the periods in which it should have been recorded. We recorded amortization of deferred stock compensation expense, net of reversals, of $0.1million, $1.1 million, and $0.7 million for fiscal 2005, fiscal 2004, and 2003, respectively. As of July 3, 2005, we have expensed all of the deferred stock-based compensation associated with the acquisitions. 76Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Stockholders’ Rights Agreement In April 2001, the board of directors approved a Stockholders’ Rights Agreement (“Rights Agreement”), declaring a dividend of one preferred sharepurchase right for each outstanding share of common stock, par value $0.001 per share, of Extreme Networks common stock. The Rights Agreement isintended to protect stockholders’ rights in the event of an unsolicited takeover attempt. It is not intended to prevent a takeover of Extreme Networks on termsthat are favorable and fair to all stockholders and will not interfere with a merger approved by the board of directors. In the event the rights becomeexercisable, each right entitles stockholders to buy, at an exercise price of $150 per right owned, a unit equal to a portion of a new share of Extreme NetworksSeries A preferred stock. The rights will be exercisable only if a person or a group acquires or announces a tender or exchange offer to acquire 15% or more ofour common stock. The rights, which expire in April 2011, are redeemable for $0.001 per right at the approval of the board of directors. Stock Option Exchange Program On March 25, 2003, we filed a Tender Offer Statement on Schedule TO with the Securities and Exchange Commission related to a voluntary stockoption exchange program for our employees. Our executive officers, directors and sales executives who report directly to the Vice President, Worldwide Saleswere not eligible to participate in this program. Under the program, eligible employees were given the opportunity to voluntarily cancel unexercised vestedand unvested stock options previously granted to them that had an exercise price greater than $12.00. For each option for five shares tendered forcancellation, a new option for three shares was granted to employees who elected to participate in the option exchange program. In order to receive new stockoptions, an employee must have been employed by us or by one of our subsidiaries on October 23, 2003 when the replacement options were granted.Participants who elected to exchange any options were required to exchange all eligible options and were also required to exchange any other optionsgranted to him or her in the previous six months. The replacement stock options vested 25% on October 23, 2003 and the remaining 75% of the replacementstock options vest monthly over 24 to 36 months based on the employee’s hire date. Options for approximately 11.0 million shares of common stock held by570 employees were eligible for exchange under the program. Options for approximately 9.3 million shares of common stock held by 435 employees wereaccepted for exchange under this program and, accordingly, were canceled on April 22, 2003. Replacement options for approximately 5.1 million shares ofcommon stock were issued on October 23, 2003 at an exercise price of $7.07 per share, which was the fair market value of our common stock on October 23,2003. The stock option exchange program did not result in any stock compensation expense or variable accounting for replacement awards. Comprehensive Income (Loss) The activity of other comprehensive income (loss) was as follows (in thousands): Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Unrealized gain (loss) on investments: Change in net unrealized gain (loss) on investments $(441) $(5,127) $755 Less: Net gain on investments realized and included in net income(loss) 99 33 307 Net unrealized gain (loss) on investments (540) (5,160) 448 Unrealized gain (loss) on derivatives 12 (1) 114 Foreign currency translation adjustments 29 467 (107) Other comprehensive income (loss) $(499) $(4,694) $455 77Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) The following are the components of accumulated other comprehensive income (loss), net of tax (in thousands): July 3, 2005 June 27, 2004 Accumulated unrealized loss on investments, net of tax of $156 in fiscal 2005 and $998 in fiscal2004 $(3,451) $(2,911)Accumulated unrealized gain on derivatives 12 — Accumulated foreign currency translation adjustments 552 523 Accumulated other comprehensive loss $(2,887) $(2,388) Shares Reserved for Issuance The following are shares reserved for issuance (in thousands); July 3, 2005 June 27, 2004Convertible subordinated notes 9,544 9,544Warrants 1,719 1,719Employee stock purchase plan 1,707 2,649Employee stock options 42,723 43,288 Total shares reserved for issuance 55,693 57,200 7. Employee Benefit Plans 1999 Employee Stock Purchase Plan In January 1999, the board of directors approved the adoption of Extreme Network’s 1999 Employee Stock Purchase Plan (the “Purchase Plan”). A totalof 7,000,000 shares of common stock have been reserved for issuance under the Purchase Plan. The Purchase Plan permits eligible employees to acquireshares of our common stock through periodic payroll deductions of up to 15% of total compensation. No more than 625 shares may be purchased on anypurchase date per employee. Each offering period has a maximum duration of 12 months. The price at which the common stock may be purchased is 85% ofthe lesser of the fair market value of our common stock on the first day of the applicable offering period or on the last day of the respective purchase period.Through July 3, 2005, 5,293,235 shares had been purchased under the Purchase Plan. Amended 1996 Stock Option Plan In January 1999, the board of directors approved an amendment to the 1996 Stock Option Plan (the “1996 Plan”) to (i) increase the share reserve by10,000,000 shares, (ii) to remove certain provisions which are required to be in option plans maintained by California privately-held companies and (iii) torename the 1996 Plan as the “Amended 1996 Stock Option Plan.” Under the 1996 Plan, which was originally adopted in September 1996, options may be granted for common stock, pursuant to actions by the board ofdirectors, to eligible participants. A total of 56,387,867 shares have been reserved under the 1996 Plan. Options granted are exercisable as determined by theboard of directors. Options vest over a period of time as determined by the board of directors, generally four years. The term of the 1996 Plan is ten years, andthe termination date for the plan is January 2006. As of July 3, 2005, 16,893,959 shares were available for future grant under the 1996 Plan. 78Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 2000 Stock Option Plan In March 2000, the board of directors adopted the 2000 Nonstatutory Stock Option Plan (the “2000 Plan”). Options may be granted for common stock,pursuant to actions by the board of directors, to eligible participants. Generally, only non-officer employees are eligible to participate in this stock plan,except that options may be granted to officers under this plan in connection with written offers of employment. A total of 4,000,000 shares have beenreserved under the 2000 Plan. Options vest over a period of time as determined by the board of directors, generally four years. The term of the 2000 Plan is tenyears. As of July 3, 2005, 2,891,822 shares were available for future grant under the 2000 Plan. 2001 Stock Option Plan In May 2001, the board of directors adopted the 2001 Nonstatutory Stock Option Plan (the “2001 Plan”). Options may be granted for common stock,pursuant to actions by the board of directors, to eligible participants. Generally, only non-officer employees are eligible to participate in this stock plan,except that options may be granted to officers under this plan in connection with written offers of employment. A total of 4,000,000 shares have beenreserved under the 2001 Plan. Options vest over a period of time as determined by the board of directors, generally four years. The term of the 2001 Plan is tenyears. As of July 3, 2005, 1,799,790 shares were available for future grant under the 2001 Plan. During fiscal 2005, 2004 and fiscal 2003, we granted restricted stock awards under the 2001 Plan for 27,000, 31,750 and 85,000 shares of commonstock with a weighted average grant date fair value per share of $5.61, $7.33, and $4.08, respectively, to a number of employees. The shares were placed in anescrow account and will be released to the recipients as the shares vest over periods of up to twenty-three months. If a participant terminates employmentprior to the vesting dates, the unvested shares will be canceled and returned to the 2001 Plan. We recognize compensation expense on the awards over thevesting period on the graded vested method based on an intrinsic value calculation as of the date of grant. During fiscal 2005, we recognized approximately$176,000 in research and development expense, approximately $32,000 in cost of revenues, and approximately $62,000 in sales and marketing expense. The following table summarizes stock option activity under all plans: Number ofShares Weighted-AverageExercise PricePer ShareOptions outstanding at June 30, 2002 27,822,704 $17.00Granted 4,655,195 $5.37Exercised (229,701) $4.02Canceled (20,340,656) $20.24 Options outstanding at June 29, 2003 11,907,542 $7.18Granted 13,899,622 $7.25Exercised (1,518,076) $4.78Canceled (2,837,767) $8.31 Options outstanding at June 27, 2004 21,451,321 $7.25Granted 3,884,300 $5.29Exercised (538,272) $2.95Canceled (3,659,831) $7.98 Options outstanding at July 3, 2005 21,137,518 $6.87 79Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) The following table summarizes significant ranges of outstanding and exercisable options at July 3, 2005: Options Outstanding Options ExercisableRange ofExercisePrices NumberOutstanding Weighted-AverageRemainingContractual Life Weighted-AverageExercisePrice NumberExercisable Weighted-AverageExercisePrice (In years) $ 0.01 – 4.44 3,725,235 6.33 $3.40 2,461,609 $3.06$ 4.45 – 6.09 3,508,645 8.47 $5.17 1,095,697 $5.19$ 6.13 – 6.96 1,196,282 9.12 $6.61 192,067 $6.71$ 7.07 – 7.07 5,547,277 8.31 $7.07 5,547,277 $7.07$ 7.14 – 8.12 4,635,832 8.23 $7.89 4,635,832 $7.89$ 8.16 – 56.00 2,524,247 6.84 $12.15 2,524,247 $12.15 $ 0.01 – 56.00 21,137,518 7.85 $6.87 16,456,729 $7.42 Options to purchase 8,640,396 shares were exercisable at June 27, 2004 with a weighted-average exercise price of $7.61. 401(k) Plan We provide a tax-qualified employee savings and retirement plan, commonly known as a 401(k) plan (the “Plan”), which covers our eligibleemployees. Pursuant to the Plan, employees may elect to reduce their current compensation up to the lesser of 80% or the statutorily prescribed limit of$14,000 for calendar year 2005. Effective January 1, 2005, employees age 50 or over may elect to contribute an additional $4,000. The amount of thereduction is contributed to the Plan on a pre-tax basis. We provide for discretionary matching contributions as determined by the board of directors for each calendar year. The board of directors set thematch at $0.25 for every dollar contributed by the employee up to the first 4% of pay. The same level of match was approved during the 2005, 2004 and 2003calendar years. All matching contributions vest immediately. In addition, the Plan provides for discretionary contributions as determined by the board ofdirectors each year. Our matching contributions to the Plan totaled $543,061, $504,557, and $484,010 for fiscal 2005, fiscal 2004, and fiscal 2003,respectively. No discretionary contributions were made in fiscal 2005, fiscal 2004 or fiscal 2003. 8. Income Taxes The provision for (benefit from) income taxes for fiscal 2005, fiscal 2004, and fiscal 2003 consisted of the following (in thousands): Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Current: Federal $— $— $— State 50 50 — Foreign 2,199 2,923 2,631 Total current 2,249 2,973 2,631 Deferred: Federal 766 372 109,517 State 76 37 23,167 Foreign 452 (206) (529) Total deferred 1,294 203 132,155 Provision for income taxes $3,543 $3,176 $134,786 80Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Pretax income from foreign operations was $14.4 million, $6.7 million, and $2.5 million in fiscal 2005, fiscal 2004, and fiscal 2003, respectively. The difference between the provision for income taxes and the amount computed by applying the federal statutory income tax rate (35 percent) toincome (loss) before taxes is explained below (in thousands): Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Tax at federal statutory rate (benefit) $5,770 $500 $(21,838)State income tax, net of federal benefit 81 57 15,059 Unbenefited foreign taxes 650 1,070 2,102 Unbenefited net operating losses — — 21,322 Valuation allowance (128) 1,749 117,626 Foreign earnings taxed at other than U.S. rates/unbenefited foreign loss (3,026) (702) — Nondeductible goodwill — — 357 Deferred compensation 22 371 — Other 174 131 158 Provision for income taxes $3,543 $3,176 $134,786 Significant components of our deferred tax assets are as follows (in thousands): July 3, 2005 June 27, 2004 Deferred tax assets: Net operating loss carryforwards $87,772 $80,707 Tax credit carryforwards 17,387 14,715 Depreciation 19,591 21,801 Deferred revenue 5,931 7,881 Warrant amortization 18,226 16,199 Inventory allowances 1,494 2,500 Other allowances and accruals 11,704 17,048 Other 11,483 10,946 Total deferred tax assets 173,588 171,797 Valuation allowance (173,002) (169,886) Total net deferred tax assets 586 1,911 Deferred tax liabilities: Acquisition related intangibles — (27)Unrealized gain on investments (156) (998)Deferred tax liability on foreign withholdings (757) (762) Total deferred tax liabilities (913) (1,787) Net deferred tax assets (liabilities) $(327) $124 Recorded as: Net current deferred tax assets $430 $886 Net non-current deferred tax liabilities (757) (762) Net deferred tax assets (liabilities) $(327) $124 81Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Our valuation allowance increased by $3.1 million in fiscal 2005 and increased by $6.8 million in fiscal 2004, to provide a valuation allowanceagainst all of our U.S. federal and state deferred tax assets. The valuation allowance is determined in accordance with the provisions of Statement of FinancialAccounting Standards No. 109, Accounting for Income Taxes, (“SFAS 109”), which requires an assessment of both negative and positive evidence whenmeasuring the need for a valuation allowance. Our losses in the three-year period at the time the charge was incurred represented sufficient negative evidenceto require a valuation allowance under SFAS 109. This valuation allowance will be evaluated periodically and can be reversed partially or totally if businessresults have sufficiently improved to support realization of our deferred tax assets. As of July 3, 2005, approximately $4.2 million of the valuation allowance for deferred taxes was attributable to the tax benefits of stock optiondeductions, which will be credited to equity when realized. As of July 3, 2005, we had net operating loss carryforwards for federal and state tax purposes of $248.1 million and $18.8 million, respectively. We alsohad federal and state tax credit carryforwards of $9.5 million and $12.1 million, respectively. Unused net operating loss and tax credit carryforwards willexpire at various dates beginning in the years 2006 and 2008, respectively. Utilization of the net operating losses and tax credits may be subject to a substantial annual limitation due to the ownership change limitationsprovided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operatinglosses and tax credits before utilization. 9. Disclosure about Segments of an Enterprise and Geographic Areas Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly bythe chief operating decision makers with respect to the allocation of resources and performance. We operate in one segment, the development and marketing of network infrastructure equipment. We conduct business globally and are managedgeographically. Revenue is attributed to a geographical area based on the location of the customers. Information regarding geographic areas is as follows (in thousands): Year Ended July 3, 2005 June 27, 2004 June 29, 2003Net revenues: United States $167,027 $136,622 $144,066Europe, Middle East and Africa 117,521 93,700 90,303Japan 58,100 77,600 82,916Other 40,699 43,926 45,991 $383,347 $351,848 $363,276 Substantially all of our assets were attributable to United States operations at July 3, 2005, and June 27, 2004. 82Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 10. Net Income (Loss) Per Share Basic earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during theperiod, less shares subject to repurchase, and excludes any dilutive effects of options, warrants and convertible subordinated notes. Dilutive earnings (loss)per share is calculated by dividing net income by the weighted average number of common shares used in the basic earnings (loss) per share calculation plusthe dilutive effect of shares subject to repurchase, options, warrants and convertible subordinated notes. Diluted net loss per share was the same as basic netloss per share in fiscal 2004 and fiscal 2003 because we had net losses in those periods. The following table presents the calculation of basic and diluted netincome (loss) per share (in thousands, except per share data): Year Ended July 3, 2005 June 27, 2004 June 29, 2003 Net income (loss) $12,942 $(1,748) $(197,180) Weighted-average shares of common stock outstanding 121,225 118,450 115,742 Less: Weighted-average shares subject to repurchase — (102) (556) Weighted-average shares used in per share calculation — basic 121,225 118,348 115,186 Incremental shares using the treasury stock method 2,994 — — Weighted-average shares used in per share calculation — diluted 124,219 118,348 115,186 Net income (loss) per share — basic $0.11 $(0.01) $(1.71) Net income (loss) per share — diluted $0.10 $(0.01) $(1.71) The following table sets forth potential shares of common stock that are not included in the diluted net income (loss) per share calculation abovebecause to do so would be anti-dilutive for the periods presented (in thousands): Year Ended July 3, 2005 June 27, 2004 June 29, 2003Stock options outstanding: In-the-money options — 2,177 1,567Out-of-the-money options 15,642 5,614 19,988Warrants outstanding — 1,493 — Unvested common stock subject to repurchase — 102 556Convertible subordinated notes 9,542 9,542 9,542 Total potential shares of common stock excluded from the computation of earnings per share 25,184 18,928 31,653 The computation of diluted earnings (loss) per share excludes the impact of the conversion of the convertible subordinated notes, which areconvertible into approximately 9.5 million shares of common stock, as the impact of adding back to income the after tax interest expense associated with theconvertible subordinated notes, and including the impact of the common shares to be issued, would be anti-dilutive in the periods presented. Stock options outstanding with an exercise price lower than the Company’s average stock price for the periods presented (“In-the-money options”) areexcluded from the calculation of diluted net loss per share since the effect would have been anti-dilutive due to the net loss. Stock options outstanding withan exercise price higher than the Company’s average stock price for the periods presented (“Out-of-the-money options”) are excluded from the calculation ofdiluted net income (loss) per share since the effect would have been anti-dilutive under the treasury stock method. 83Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 11. Foreign Currency Hedging SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), as amended and interpreted, requires that all derivativesbe recorded on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify, or are not effective as hedges, must be recognizedcurrently in earnings. Accordingly, we record the forward contracts used to manage foreign exchange exposures in prepaid expenses and other current assetson the consolidated balance sheets at fair value. Foreign Exchange Exposure Management - We denominate substantially all global sales in U.S. dollars. International sales subsidiaries generateoperating expenses in foreign currencies. We have a program of hedging forecasted and actual foreign currency risk with forward contracts to eliminate,reduce or transfer selected foreign currency risks that can be confidently identified and quantified. Hedges of anticipated transactions are designated anddocumented at inception as cash flow hedges and are evaluated for effectiveness at least quarterly. As the critical terms of the forward contract and theunderlying are matched at inception, forward contract effectiveness is calculated by comparing the cumulative change in the contract (on a forward toforward basis) to the change in fair value of the anticipated expense, with the effective portion of the hedge recorded in accumulated other comprehensiveincome (“OCI”). Values accumulated in OCI are subsequently reclassified into the consolidated statement of operations line item to which the hedgedtransaction relates in the period the anticipated expense is recognized in income. Any ineffectiveness is recognized immediately in other expense. Noineffectiveness was recognized in other expense in fiscal 2005, fiscal 2004, or fiscal 2003. Forward contracts used to hedge the remeasurement of non-functional currency monetary assets and liabilities are recognized in other expensecurrently to mitigate reported foreign exchange gains and losses. Forward contracts generally have maturities of 60 days or less. 12. Restructuring Charges, Property and Equipment Write-Off and Technology Agreement Restructuring Charges As of July 3, 2005, restructuring liabilities were $19.9 million and consisted of obligations under excess facility operating leases, net of projectedfuture sublease receipts. The excess facility charge was initially recognized during fiscal 2002 to permanently reduce occupancy or vacate certain domesticand international facilities. At several of the facilities, we have not yet been able to find suitable tenants to sublease the facilities. The commercial real estatemarket in these areas continues to be weak. The actual cost could differ from this estimate, and additional facilities charges could be incurred if we areunsuccessful in negotiating reasonable termination fees on certain facilities, if facility operating lease rental rates continue to decrease in these markets, if ittakes longer than expected to find a suitable tenant to sublease these facilities or if other estimates and assumptions change. During fiscal 2004, we recorded restructuring charges of $6.5 million due to lower projected sublease income related to excess facilities because thecommercial real estate market continued to deteriorate in fiscal 2004 and we had not found suitable tenants to sublease these facilities. The lower projectedsublease income necessitated an increase in the liability to take into consideration the unfavorable difference between lease obligation payments andprojected sublease receipts. During fiscal 2003, we recorded restructuring charges of $15.9 million. The restructuring charges included excess facilities charges of $9.6 million,severance charges of $4.4 million and asset impairments of $1.9 million. The excess facilities charge represents an increase to the charge recognized duringfiscal 2002. Severance charges of $2.7 million related to a reduction in total staff during the second quarter of fiscal 2003 of approximately 100 people, or10% of the total workforce, across all departments. Severance charges of 84Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) $1.7 million related to a reduction in total staff announced at the end of the fiscal year of approximately 70 people, or 8% of the total workforce, across alldepartments. The asset impairment charge relates to the write-off of leasehold improvements and office furniture related to excess facilities. Restructuring liabilities consist of (in thousands): ExcessFacilities AssetImpairments Severance Total Balance at June 30, 2002 $23,421 — — $23,421 Charge in second quarter of fiscal 2003 9,576 $1,893 $2,718 14,187 Charge in fourth quarter of fiscal 2003 — — 1,752 1,752 Write-offs — (1,893) — (1,893)Cash payments (6,579) — (2,718) (9,297) Balance at June 29, 2003 26,418 — 1,752 28,170 Charge in first quarter of fiscal 2004 876 122 (36) 962 Charge in fourth quarter of fiscal 2004 5,622 — (97) 5,525 Write-offs — (122) — (122)Cash payments (6,353) — (1,619) (7,972) Balance at June 27, 2004 26,563 — — 26,563 Cash Payments (6,607) — — (6,607) Balance at July 3, 2005 19,956 — — 19,956 Less: current portion 6,066 — — 6,066 Restructuring liabilities at July 3, 2005, less current portion $13,890 $— $— $13,890 Property and Equipment Write-off During the second quarter of fiscal 2003, we completed a property and equipment physical inventory in conjunction with the implementation of ournew ERP system. The property and equipment physical inventory resulted in the identification of $12.7 million of property and equipment whose fair valuewas determined to be zero because the assets were either no longer in service or were not identifiable. Therefore these assets were written-off during thesecond quarter of fiscal 2003. Technology Agreement On March 31, 2005, we entered into a Patent and Cross License Agreement (“Technology Agreement”) with IBM. The agreement provides for a releaseof prior claims and a cross license of patents extending into the future from the effective date of the agreement. We charged the estimated value of the releaseof prior claims of $2.0 million to operating expenses in the quarter ended March 27, 2005 under the caption “Technology agreement”. The remaining valueunder this agreement has been recognized in other assets and is being amortized to cost of product revenue over its contractual period using the straight-linemethod of amortization. 13. Alliance with Avaya On October 30, 2003, Extreme Networks and Avaya Inc. entered into a strategic alliance to jointly develop and market converged communicationssolutions, by executing a Joint Development Agreement, and a distribution agreement under which Avaya is entitled to resell Extreme Networks products.Extreme issued to 85Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Avaya a warrant with a ten-year expiration period to purchase up to 2,577,794 shares of Extreme Networks common stock at a price of $0.01 per share, withAvaya having the right to exercise the warrant with respect to one third of such shares 90 days after the date of the agreements, and the remaining sharesbecome exercisable based upon the completion of certain milestones by Avaya. Even if the milestones are not completed, however, the warrant will becomefully exercisable for all shares 90 days prior to the expiration of the warrant. Avaya exercised the warrant with respect to one third of the shares subject to thewarrant on March 17, 2004 and, accordingly, approximately 859,000 shares of our common stock were issued to Avaya on that date. We engaged an independent valuation firm to assist us in estimating the fair value of the warrant and to assist us with the allocation of the fair value tothe two agreements entered into. The independent valuation firm estimated the fair value of the warrant at $22.7 million, which has been allocated $17.9million to the Joint Development Agreement and $4.8 million to the distribution agreement based on the assumptions by management related to theprojected revenue and expenses for the respective agreements. The fair value of the warrant, net of accumulated amortization, is recorded in other assets in ourconsolidated balance sheets. The values assigned to the respective agreements are being amortized over the three-year term of the agreements. The amortization of the warrant costrelated to the Joint Development Agreement charged as research and development expense was $6.0 million in fiscal 2005, and $4.0 million in fiscal 2004.The amortization related to the distribution agreement included as contra-revenue in product net revenue was $1.6 million and $1.1 million in fiscal 2005and 2004, respectively. 14. Quarterly Financial Data (Unaudited) (In thousands, except share and per share amounts) July 3,2005 Mar. 27,2005 (1) Dec. 26,2004 (2) Sept. 26,2004Net revenues $96,052 $91,908 $100,301 $95,086Gross margin $50,877 $47,262 $53,957 $50,556Net income (loss) $123 $(1,257) $9,950 $4,126Net income (loss) per share — basic $0.00 $(0.01) $0.08 $0.03Net income (loss) per share — diluted $0.00 $(0.01) $0.08 $0.03 June 27,2004 (3) Mar. 28,2004 (4) Dec. 28,2003 (5) Sept. 28,2003 (6)Net revenues $92,158 $88,874 $83,445 $87,371Gross margin $48,378 $45,473 $40,442 $44,903Net income (loss) $2,349 $(1,106) $(5,606) $2,615Net income (loss) per share — basic $0.02 $(0.01) $(0.05) $0.02Net income (loss) per share — diluted $0.02 $(0.01) $(0.05) $0.02(1)Net loss and net loss per share include an operating expense of $2.0 million related to the execution of a technology agreement.(2)Net income and net income per share include other income of $3.9 million from the relief of a foreign consumption tax obligation.(3)Net income and net income per share include amortization of deferred stock compensation of $0.1 million, restructuring charges for excess facilities of$5.5 million, cash settlement from vendors, net of related expenses, of $5.7 million and other income from the relief of a foreign consumption taxobligation of $2.5 million. 86Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) (4)Net loss and net loss per share include amortization of deferred stock compensation of $0.2 million.(5)Net loss and net loss per share include amortization of deferred stock compensation of $0.2 million.(6)Net income and net income per share include amortization of deferred stock compensation of $0.6 million, restructuring charges for excess facilities of$1.0 million, and settlement of litigation, net of related expenses, of $2.2 million. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we evaluated theeffectiveness of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, asamended. Based on this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this annual report in providing reasonable assurance that information required to be disclosed by ExtremeNetworks in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities andExchange Commission rules and forms. Management’s Report on Internal Control over Financial Reporting Extreme Networks Inc.’s management is responsible for establishing and maintaining adequate internal control over the company’s financial reporting.There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and the circumvention oroverriding of controls. Accordingly, even effective internal controls can provide only reasonable assurances with respect to financial statement preparation.Further because of changes in conditions, the effectiveness of internal control may vary over time. We assessed the effectiveness of the company’s internal control over financial reporting as of July 3, 2005. In making this assessment, we used thecriteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment using those criteria, we concluded that, as of July 3, 2005, Extreme Networks Inc.’s internal control over financial reporting iseffective. Extreme Networks Inc.’s independent registered public accounting firm, Ernst & Young LLP, has audited the financial statements included in thisAnnual Report on Form 10-K and has issued its report on management’s assessment of the effectiveness of the Company’s internal control over financialreporting as of July 3, 2005. This report appears on page 88 of this Annual Report on Form 10-K. Change in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting during the quarter ended July 3, 2005 that have materially affected, or arereasonably likely to materially affect, our internal control over financial reporting. 87Table of ContentsReport of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting The Board of Directors and StockholdersExtreme Networks, Inc. We have audited management’s assessment, included in the accompanying report entitled “Management’s Report on Internal Control over FinancialReporting,” that Extreme Networks, Inc. maintained effective internal control over financial reporting as of July 3, 2005, based on criteria established inInternal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). ExtremeNetworks, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of thecompany’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on thefinancial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of anyevaluation of the effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Extreme Networks, Inc. maintained effective internal control over financial reporting as of July 3, 2005,is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Extreme Networks, Inc. maintained, in all material respects, effectiveinternal control over financial reporting as of July 3, 2005, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balancesheets of Extreme Networks, Inc. as of July 3, 2005 and June 27, 2004, and the related consolidated statements of operations, stockholders’ equity, and cashflows for each of the three years in the period ended July 3, 2005 of Extreme Networks, Inc. and our report dated September 6, 2005 expressed an unqualifiedopinion thereon. /s/ Ernst & Young LLP Palo Alto, CaliforniaSeptember 6, 2005 88Table of Contents PART III Certain information required by Part III is incorporated by reference from Extreme’s definitive Proxy Statement to be filed with the Securities andExchange Commission in connection with the solicitation of proxies for Extreme’s 2005 Annual Meeting of Stockholders (the “Proxy Statement”) not laterthan 120 days after the end of the fiscal year covered by this report, and certain information therein is incorporated in this report by reference. Item 10. Directors and Executive Officers of the Registrant The information required by this section is incorporated by reference from the information in the section entitled “Proposal 1 – Election of Directors”in the Proxy Statement. The required information concerning executive officers of Extreme is contained in the section entitled “Executive Officers of theRegistrant” in Part I of this Form 10-K. Item 405 of Regulation S-K calls for disclosure of any known late filing or failure by an insider to file a report required by Section 16 of the ExchangeAct. This disclosure is contained in the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and isincorporated herein by reference. Information with respect to Item 406 of Regulation S-K is incorporated by reference to the information contained in the section captioned “Code ofEthics” in the Proxy Statement. Item 11. Executive Compensation The information required by this section is incorporated by reference from the information in the sections entitled “Directors’ Compensation”,“Executive Compensation”, “Report of the Compensation Committee on Executive Compensation” and “Stock Price Performance Graph” in the ProxyStatement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this section is incorporated by reference from the information in the section entitled “Security Ownership of CertainBeneficial Owners and Management” in the Proxy Statement. The information required by this section regarding securities authorized for issuance under equity compensation plans is incorporated by referencefrom the information in the section entitled “Equity Compensation Plan Information” in the Proxy Statement. Item 13. Certain Relationships and Related Transactions The information required by this section is incorporated by reference from the information in the section titled “Certain Relationships and RelatedTransactions” in the Proxy Statement. Item 14. Principal Accounting Fees and Services The information required by this section is incorporated by reference from the information in the section titled “Principal Accounting Fees andServices” in the Proxy Statement. PART IV Item 15. Exhibits and Financial Statement Schedules (a) The following documents are filed as a part of this Form 10-K: (1) Financial Statements: Reference is made to the Index to Consolidated Financial Statements of Extreme Networks, Inc. under Item 8 in Part II of this Form 10-K. 89Table of Contents(2) Financial Statement Schedules: The following financial statement schedule of Extreme Networks, Inc. for the fiscal years ended July 3, 2005, June 27, 2004, and June 29, 2003 is filedas part of this Report and should be read in conjunction with the Consolidated Financial Statements of Extreme Networks, Inc. PageSchedule II — Valuation and Qualifying Accounts 92 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Exhibits: The exhibits listed below are required by Item 601 of Regulation S-K. Each management contract or compensatory plan or arrangement required to befiled as an exhibit to this Form 10-K has been identified. ExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form Filing Date Number 2.1 Form of Agreement and Plan of Merger between Extreme Networks, a Californiacorporation, and Extreme Networks, Inc., a Delaware corporation. S – 1/A 03/11/99 2.1 3.1 Certificate of Incorporation of Extreme Networks, Inc., a Delaware Corporation. S – 1 02/05/99 3.1 3.2 Form of Certificate of Amendment of Certificate of Incorporation of ExtremeNetworks, Inc., a Delaware Corporation. S – 1 02/05/99 3.2 3.4 Amended and Restated Bylaws of Extreme Networks, Inc. 8 – K/A 06/07/01 3.4 3.5 Restated Certificate of Incorporation of Extreme Networks, Inc. 10 – K 09/26/01 3.5 3.6 Certificate of Amendment of Restated Certificate of Incorporation of ExtremeNetworks, Inc. 10 – K 09/26/01 3.6 3.7 Certificate of Designation, Preferences and Rights of the Terms of the Series APreferred Stock. 10 – K 09/26/01 3.7 4.1 Second Amended and Restated Rights Agreement dated January 12, 1998 betweenExtreme Network and certain stockholders. S – 1 02/05/99 4.1 4.2 Rights Agreement dated April 27, 2001 between Extreme Networks, Inc. and MellonInvestor Services LLC. 8 – K/A 06/07/01 4.2 4.3 Indenture, dated December 5, 2001 between Extreme Networks, Inc. and State StreetBank and Trust Company of California, N.A. S – 3 02/26/02 4.3 4.4 Registration Rights Agreement dated December 5, 2001 between Extreme Networks,Inc. and Goldman Sachs & Co., as representative. S – 3 02/26/02 4.4 4.5 Warrant to Purchase Common Stock issued to Avaya, Inc. S – 3 01/28/04 4.1 90Table of ContentsExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form Filing Date Number 10.1 Form of Indemnification Agreement for directors and officers. S – 1 02/05/99 10.1 10.2* Amended 1996 Stock Option Plan and forms of agreements thereunder. S – 1 02/05/99 10.2 10.3* 1999 Employee Stock Purchase Plan. S – 1 02/05/99 10.3 10.4* 2000 Nonstatutory Stock Option Plan. 10 – K 09/24/00 10.7 10.5 Exhibit 10.14 Lease agreement dated July 28, 2000 between San Tomas PropertiesLLC, a Delaware limited liability company, as Landlord, and Extreme Networks, Inc, aDelaware Corporation, as Tenant. 10 – Q 11/14/00 10.14 10.6 Purchase Agreement dated November 29, 2001 between Extreme Networks, Inc. andGoldman Sachs & Co., as representative. S – 3 02/26/02 10.15 10.7 2001 Nonstatutory Stock Option Plan. Schedule TO 10/31/01 (d)(9) 12.1 Statement re: Computation of Ratios. X21.1 Subsidiaries of Registrant. X23.1 Consent of Independent Registered Public Accounting Firm. X24.1 Power of Attorney (see page 93 of this Form 10-K). X31.1 Section 302 Certification of Chief Executive Officer. X31.2 Section 302 Certification of Chief Financial Officer. X32.1 Section 906 Certification of Chief Executive Officer. X32.2 Section 906 Certification of Chief Financial Officer. X*Indicates management contract or compensatory plan or arrangement. 91Table of ContentsSCHEDULE II VALUATION AND QUALIFYING ACCOUNTSYEARS ENDED JULY 3, 2005, JUNE 27, 2004, AND JUNE 29, 2003(In thousands) Description Balance atbeginning ofperiod Chargedto costsandexpenses Reversalsto costs andexpenses Chargedto otheraccounts (Deductions) Balance atend ofperiodYear Ended June 29, 2003: Allowance for doubtful accounts $2,736 $— $(823) $— $418* $2,331Allowance for sales returns $8,962 $— $— $— $(5,358) $3,604Inventory valuation $18,067 $402 $— $— $(10,140) $8,329Allowance for net deferred tax assets $— $163,127 $— $— $— $163,127Year Ended June 27, 2004: Allowance for doubtful accounts $2,331 $— $(200) $(724) $(29) $1,378Allowance for sales returns $3,604 $1,818 $— $— $(3,196) $2,226Allowance for distributor doubtful accounts $— $— $— $724 $— $724Inventory valuation $8,329 $1,252 $— $— $(3,216) $6,365Allowance for net deferred tax assets $163,127 $6,759 $— $— $— $169,886Year Ended July 3, 2005: Allowance for doubtful accounts $1,378 $58 $(110) $ $(79) $1,247Allowance for sales returns $2,226 $1,344 $(300) $— $(945) $2,325Allowance for distributor doubtful accounts $724 $532 $(100) $ $(537) $619Inventory valuation $6,365 $1,061 $— $— $(2,636) $4,790Allowance for net deferred tax assets $169,886 $3,116 $— $— $— $173,002*The amount for the year ended June 29, 2003 is an increase due to the fact that we had net recoveries of amounts that were previously written-off in excessof current year write-offs. 92Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized, on September 7, 2005. EXTREME NETWORKS, INC.(Registrant)By: /s/ WILLIAM R. SLAKEY William R. Slakey Senior Vice President Chief Financial OfficerSeptember 7, 2005 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Gordon L. Stitt and WilliamR. Slakey, and each of them, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to signany amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities andExchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done byvirtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the date indicated: /s/ MIKE WEST /s/ GORDON L. STITT Mike WestChairman of the BoardSeptember 7, 2005 Gordon L. StittPresident, Chief Executive OfficerSeptember 7, 2005/s/ WILLIAM R. SLAKEY /s/ BOB L. COREY William R. SlakeySenior Vice President & Chief Financial Officer(Principal Financial and Accounting Officer)September 7, 2005 Bob L. CoreyDirectorSeptember 7, 2005/s/ CHARLES CARINALLI /s/ HARRY SILVERGLIDE Charles CarinalliDirectorSeptember 7, 2005 Harry SilverglideDirectorSeptember 7, 2005/s/ KENNETH LEVY Kenneth LevyDirectorSeptember 7, 2005 93Table of ContentsEXHIBIT INDEX ExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form FilingDate Number 2.1 Form of Agreement and Plan of Merger between Extreme Networks, a Californiacorporation, and Extreme Networks, Inc., a Delaware corporation. S – 1/A 03/11/99 2.1 3.1 Certificate of Incorporation of Extreme Networks, Inc., a Delaware Corporation. S – 1 02/05/99 3.1 3.2 Form of Certificate of Amendment of Certificate of Incorporation of Extreme Networks,Inc., a Delaware Corporation. S – 1 02/05/99 3.2 3.4 Amended and Restated Bylaws of Extreme Networks, Inc. 8 –K/A 06/07/01 3.4 3.5 Restated Certificate of Incorporation of Extreme Networks, Inc. 10 – K 09/26/01 3.5 3.6 Certificate of Amendment of Restated Certificate of Incorporation of ExtremeNetworks, Inc. 10 – K 09/26/01 3.6 3.7 Certificate of Designation, Preferences and Rights of the Terms of the Series APreferred Stock. 10 – K 09/26/01 3.7 4.1 Second Amended and Restated Rights Agreement dated January 12, 1998 betweenExtreme Network and certain stockholders. S – 1 02/05/99 4.1 4.2 Rights Agreement dated April 27, 2001 between Extreme Networks, Inc. and MellonInvestor Services LLC. 8 –K/A 06/07/01 4.2 4.3 Indenture, dated December 5, 2001 between Extreme Networks, Inc. and State StreetBank and Trust Company of California, N.A. S – 3 02/26/02 4.3 4.4 Registration Rights Agreement dated December 5, 2001 between Extreme Networks,Inc. and Goldman Sachs & Co., as representative S – 3 02/26/02 4.4 4.5 Warrant to Purchase Common Stock issued to Avaya, Inc. S – 3 01/28/04 4.1 10.1 Form of Indemnification Agreement for directors and officers. S – 1 02/05/99 10.1 10.2* Amended 1996 Stock Option Plan and forms of agreements thereunder. S – 1 02/05/99 10.2 10.3* 1999 Employee Stock Purchase Plan. S – 1 02/05/99 10.3 10.4* 2000 Nonstatutory Stock Option Plan. 10 – K 09/24/00 10.7 10.5 Exhibit 10.14 Lease agreement dated July 28, 2000 between San Tomas PropertiesLLC, a Delaware limited liability company, as Landlord, and Extreme Networks, Inc, aDelaware Corporation, as Tenant. 10 – Q 11/14/00 10.14 94Table of ContentsExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form FilingDate Number 10.6 Purchase Agreement dated November 29, 2001 between Extreme Networks, Inc. andGoldman Sachs & Co., as representative. S – 3 02/26/02 10.15 10.7 2001 Nonstatutory Stock Option Plan. ScheduleTO 10/31/01 (d)(9) 12.1 Statement re: Computation of Ratios. X21.1 Subsidiaries of Registrant. X23.1 Consent of Independent Registered Public Accounting Firm. X24.1 Power of Attorney (see page 93 of this Form 10-K). X31.1 Section 302 Certification of Chief Executive Officer. X31.2 Section 302 Certification of Chief Financial Officer. X32.1 Section 906 Certification of Chief Executive Officer. X32.2 Section 906 Certification of Chief Financial Officer. X*Indicates management contract or compensatory plan or arrangement. 95EXHIBIT 12.1 Statement re: Computation of Ratios (in thousands, except ratio of earnings) Years ended July 3, 2005 June 27, 2004 June 29, 2003 Income (loss) from continuing operations before taxes $16,485 $1,428 $(62,394)Fixed charges from continuing operations: Interest expense and amortization of debt discount on all indebtedness 8,355 8,354 8,191 Interest included in rent 2,300 2,400 2,700 Total fixed charges from continuing operations 10,655 10,754 10,891 Income (loss) before taxes and fixed charges $27,140 $12,182 $(51,503) Deficiency of earnings (as defined) to fixed charges — — $(62,394) Ratio of earnings to fixed charges (1) 2.55 1.13 — (1)For purposes of computing the ratio of earnings to fixed charges, earnings consist of income (loss) before provision for income taxes plus fixed charges.Fixed charges consist of interest charges and that portion of rental expense that we believe to be representative of interest. Earnings were inadequate tocover fixed charges in fiscal 2003.EXHIBIT 21.1 SUBSIDIARIES OF REGISTRANT NAME LOCATIONExtreme Networks International Cayman IslandsExtreme Networks Japan K.K. JapanExtreme Networks Hong Kong Limited Hong KongExtreme Networks IHC, Inc. DelawareExtreme Networks UK Limited United KingdomExtreme Networks B.V. The NetherlandsExtreme Networks GmbH GermanyExtreme Networks Sarl FranceExtreme Networks Srl ItalyExtreme Networks Canada, Inc. CanadaExtreme Networks Korea, Ltd. KoreaIHC Networks AB SwedenExtreme Networks Australia PTE, Ltd. AustraliaExtreme Networks EMEA DubaiExtreme Networks Argentina, SRL ArgentinaExtreme Networks Brasil, Ltda. BrazilExtreme Networks Mexico, Ltda. MexicoExtreme Networks Chile, Ltda. ChileExtreme Networks Singapore PTE, Ltd. SingaporeExtreme Networks China Ltd. ChinaExtreme Networks Spain, SL SpainExtreme Networks Switzerland GmbH SwitzerlandExtreme Networks India Private Limited IndiaExtreme Networks Mauritius MauritiusExhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the following Registration Statements: Form Number Registration Statement Number DescriptionForm S-8 333-112831 Extreme Networks, Inc. Amended 1996 Stock Option Plan and 1999Employee Stock Purchase PlanForm S-3 333-112281 Common Stock Issuable on Exercise of WarrantForm S-8 333-105767 Extreme Networks, Inc. Amended 1996 Stock Option PlanForm S-8 333-76798 Extreme Networks, Inc. Amended 1996 Stock Option PlanForm S-8 333-65636 Extreme Networks, Inc. 2001 Nonstatutory Stock Option PlanForm S-8 333-58634 Extreme Networks, Inc. Individual Option Agreements Granted Underthe Webstacks, Inc. 2000 Stock Option Plan and Assumed by ExtremeNetworks, Inc.Form S-8 333-55644 Extreme Networks, Inc. Individual Option Agreements Granted Underthe Optranet, Inc. 2000 Option Plan and Assumed by Extreme Networks,Inc.Form S-8 333-54278 Extreme Networks, Inc. Amended 1996 Stock Option Plan, 1999Employee Stock Purchase Plan and 2000 Nonstautory Stock Option Plan of our reports dated September 6, 2005, with respect to the consolidated financial statements and schedule of Extreme Networks, Inc., Extreme Networks, Inc.management’s assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting ofExtreme Networks, Inc., included in this Annual Report (Form 10-K) for the year ended July 3, 2005. /s/ Ernst & Young LLP Palo Alto, CaliforniaSeptember 6, 2005EXHIBIT 31.1 I, Gordon L. Stitt, Chief Executive Officer of the Company, certify that: 1.I have reviewed this annual report on Form 10-K of Extreme Networks, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report; 4.The Company’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the Company and have: (a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; (b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accounting principles; (c)Evaluated the effectiveness of the Company’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d)Disclosed in this report any change in the Company’s internal control over financial reporting that occurred during the Company’s mostrecent fiscal quarter (the Company’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financial reporting; and 5.The Company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theCompany’s auditors and the audit committee of the Company’s board of directors (or persons performing the equivalent function): (a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the Company’s ability to record, process, summarize and report financial information; and (b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company’s internalcontrol over financial reporting. Dated: September 7, 2005 /s/ GORDON L. STITT Gordon L. Stitt Chief Executive OfficerEXHIBIT 31.2 I, William R. Slakey, Chief Financial Officer, certify that: 1.I have reviewed this annual report on Form 10-K of Extreme Networks, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report; 4.The Company’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))for the Company and have: (a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; (b)Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under oursupervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accounting principles; (c)Evaluated the effectiveness of the Company’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d)Disclosed in this report any change in the Company’s internal control over financial reporting that occurred during the Company’s mostrecent fiscal quarter (the Company’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financial reporting; and 5.The Company’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theCompany’s auditors and the audit committee of the Company’s board of directors (or persons performing the equivalent function): (a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the Company’s ability to record, process, summarize and report financial information; and (b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company’s internalcontrol over financial reporting. Dated: September 7, 2005 /s/ WILLIAM R. SLAKEY William R. Slakey Chief Financial OfficerEXHIBIT 32.1 CERTIFICATION PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Extreme Networks, Inc. (the “Company”) on Form 10-K for the fiscal year ended July 3, 2005, as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacity and on the date indicated below, hereby certifies,pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of their knowledge: (1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and (2)The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ GORDON L. STITTGordon L. StittChief Executive OfficerSeptember 7, 2005 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signaturethat appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will beretained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.EXHIBIT 32.2 CERTIFICATION PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Extreme Networks, Inc. (the “Company”) on Form 10-K for the fiscal year ended July 3, 2005, as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacity and on the date indicated below, hereby certifies,pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of their knowledge: (1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and (2)The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ WILLIAM R. SLAKEYWilliam R. SlakeyChief Financial OfficerSeptember 7, 2005 A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signaturethat appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will beretained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

Continue reading text version or see original annual report in PDF format above